March 27, 2000

Eugenia Cheng

Anne Rivers

Mark Stencik

Anne Weidlich

Fei Zhao

Asia has become an economically powerful region, supplying much of the world with their exports and teaching the rest of the world new management techniques. However, the financial markets in Asia, particularly China and Taiwan, have lagged those in other regions. The United States boasts equity markets with over 5,000 listed companies, Europe has over 3,000 listed stocks and South America has grown significantly in the past few decades. In contrast, China has approximately 800 companies listed with only separate shares available to non-local residents. In Taiwan, less than 500 companies are listed on the Taiwan Stock Exchange with the government maintaining restrictions on foreign investment.

Both Taiwan and China have developing financial markets that are continuing to grow. Today, the governments of Taiwan and China have the benefit of observing markets around the world and adopting the best-practices identified. In this way, Taiwan and China will be able to develop their markets after watching the history of mistakes and successes of others.

From a business perspective, Taiwan relies on Mainland China for both manufacturing and sales. China’s entry into the WTO places Taiwan in the opportunistic position to exploit the Mainland’s huge market. On the other hand, China has the benefit of watching Taiwan’s slow approach to capital reform, as Taiwan has been developing its market for over 40 years. In many ways the developments Taiwan has made in its financial sector could serve as a blue print for China’s economic reform.

Taiwan Today

The political changes in Taiwan have left the financial markets on shaky ground. The election of Chen Shui-bian over the KMT party who has ruled for the past 20 years has increased tensions with China, and has brought the added uncertainty of a new governing party, the Democratic Progressive Party, DPP. It is expected that the Taiwan and Hong Kong central banks will try to stabilize the currency, but analysts expect the impact on the financial market to be negative.

The advent of a new ruling party may be a good opportunity for the financial markets to adopt changes that will help them prepare for the 21^st Century. The government could choose to implement these changes in the wake of a poor market as an effort to make it stronger in the short and long run. Implementing such changes in a positive market could be more difficult because of the perceived negative effect it could cause; however, implementing some of the best-practices seen in other countries in a negative market could cause the market to rise.

China Today

This paper analyzes the history of the financial markets of both Taiwan and China, with special focus on the implications from changes in the political and economic environments. While each market has become more accessible to local and foreign investors over the last decade, there are several key developments that each market could implement to help each become a financial leader in the 21^st Century. Taiwan and China should look to other OCED economies to determine the best practices that could be implemented. In addition, China should look to Taiwan for direction. Consequently, Taiwan and China have the potential to become international financial centers.

In the Cairo Declaration of the Allied powers at the end of World War II, Taiwan was transferred from Japan to the Republic of China which was under the rule of Chaing Kai-Shek. President Chaing Kai-Shek sent Chen Yi to control Taiwan in 1945. Yi installed a powerful authoritarian regime and monopolized tea, sugar, tobacco, all alcohol products and all foreign trade.

Although Taiwan has made significant progress in becoming a more democratic society, the transition has not been seamless. In 1947, 10,000 to 20,000 Taiwanese were killed in what became known as the "Incident". Due to the strict prohibitions on alcohol and tobacco products put on by Chen Yi, the police checked pedestrians for any tobacco or alcohol products. During one such search, a woman was thrown to the ground by the police and when a few onlookers came to her assistance the officers shot them. In a protest of the shootings several protests were staged and a committee was formed to discuss with Chen Yi. In the meeting, the group discussed many issues, but after Yi disbanded the meeting, he gave a list of suspects to the military to arrest. Those arrested were either killed on the spot, taken and killed or jailed, never to be seen again. The total number of Taiwanese killed by the military is not known. It is estimated that between 10,000 and 20,000 were killed in the Incident. When President Chaing Kai-Shek heard of the incident, he sent Chen Yi to a remote area of Western China. When Chen Yi tried to join the communist party he was returned to Taiwan where he was tried and killed for treason. The Incident was hidden from the world by the Chinese government until 1991.

President Chaing Kai-Shek replaced Chen Yi with Wei Tao-Ming, former ambassador to the United States. The appointment of Tao-Ming was a pivotal point in Taiwan’s development because he proceeded to institute reform, reform which reduced the monopolistic powers of the government by encouraging private ownership and installing local Taiwanese in the government.

When the communists took over China in 1949, President Chaing Kai-Shek replaced Tao-Ming with a former general and personal friend, Chen Cheng. Chen Cheng brought 300,000 troops and installed martial law.

In 1949 and 1950 the government of the Republic of China retreated to Taiwan where they remained in power until 1991. During the next forty years, regime changed and again progress was not always achieved seamlessly. Setbacks included the loss of a United Nations seat in 1970 and the United States dropping of recognition and not providing protection in 1979.

The development of Taiwan’s modern economy started after the departure of the Japanese after the war in 1945. Aftermath of the war included a damaged but fixable post-war infrastructure, the loss of a very skilled labor base and dramatically reduced production levels.

In 1950, The agricultural market focused on three crops, rice, sweet potatoes and sugar cane. By expanding and planning crop areas more efficiently, increasing the number of hours worked by laborers, replacing animal driven tools by machines and adopting the use of fertilizer and insecticides, the agricultural market was modernized over the one decade.

In 1951, the government instituted land reform to transfer ownership of land from the non-farm owners to the sharecroppers who worked the land and sold public land to tenant farmers. Under the Land-to-the-Tiller program, the government took away land from landlords who were not working the land or had more than 2.9 hectares. The landlords received bonds in kind for foodstuffs and shares in four state owned enterprises, while the government was able to sell the land to the people who worked the land. The tenant farmers were charged 2.5 times the yield of the main crop that could be paid over a ten-year period, with first priority going to the tillers of that land. In addition, the government sold the land they had acquired from the Japanese. Again, this reform proved crucial to Taiwan’s modern development as it instituted a focus on private ownership.

Primary industrialization in Taiwan occurred between 1950 and 1980. During this time, the government played a key role in the developing economy. The Taiwan economy changed as the government’s involvement changed overtime. At the beginning, circa 1947, the government controlled all resources both public and private. During the last 50 years, the government has decreased their involvement significantly allowing for a more free-market system, focused on limits instead of prohibitions.

At the beginning of industrialization in Taiwan, the government controlled all public and private resources. The government did not allow itself to be infiltrated by business. The government created interests groups to support their interests and to avoid allowing business to gain any control over the resources. The government played an interventionist economic role that guaranteed popular welfare.

Taiwan’s economy was principally controlled by small to mid-size companies with family and friends at the core of the businesses. These relationships, often called Kuan-hsi, were independent of the government. Also common in China, "Kuan-his" is the strongest economic power second to the government.

During the first stage of Taiwan’s development, the economy switched from an agrarian based economy to a manufacturing base, the first key step toward industrialization. From 1952 to 1967, real GDP as a factor of cost decreased from 35.3 to 25.3, respectively. While manufacturing and trade increased from 9.8 to 21.4 and 14.9 and 16.9, respectively.

In the 1950s Taiwan suffered from severe inflation stifling its ability to provide for the state. During this time, the government kept strong control over imports, tariffs and multiple exchange rates in order to protect Taiwan manufacturers from foreign competition. This strategy succeeded in improving the consumer product companies, but also created a large export deficit (as a result of related machinery import expense).

Heavy reliance on foreign investment played a significant role in Taiwan’s development. In the 1950s and 60s the United States offered considerable economic and military support. This support helped fuel the growth of several manufacturing industries including fertilizers, plastics and textiles. In accordance with the financial support received from the US, Taiwan also had to listen to the advice of the American Agency for International Development (AID). AID purported private enterprise and pressured Taiwan officials to liberalize economic controls. In several instances AID threatened to stop American aid if changes were not made.

In 1959, the government began removing controls; and adopted a new slogan: "Developing agriculture by virtue of industry, and fostering industry by virtue of foreign trade". The government was now willing to let market forces take more control and relax their control over all resources by promoting Taiwanese products all over the world.

During the first half of 1960, the government relaxed many controls including the gradual devaluation of the NT dollar and reduced its use of import quotas relying almost solely on tariffs to control the amounts being imported. In addition, the government developed several policies to stimulate exports. These included investment incentives, tax reductions and rebates on customs duties on raw materials to be used in manufacturing. The government also streamlined the export regulations making the system easier to navigate.

Exports became an essential ingredient in the success of Taiwan’s industrialization movement. Output expansion due to export expansion increased from 22.5% during 1956-61 to 67.7 % from 1971-1976. During the same two five year periods, output expansion due to domestic expansion decreased from 61.6% to 34.7%, respectively.

Exporting became so essential to the industrialization of Taiwan because of the labor-intensive strategy. Taiwan’s exports were more competitive internationally because of the low cost afforded by the high labor content. Taiwan experienced increased markets for their goods, greater opportunities for production and greater demand for labor. As manufacturing assumed a larger share of national production, the demand for labor increased dramatically, especially since the fastest growing manufacturing sectors were the most labor-intensive products.

Martial law, which prohibited workers from striking, created an orderly, disciplined and docile labor force that continued to grow and drive the industrialization of Taiwan.

Three major benefits of Taiwan’s export-oriented industrialization were: 1) it changed the roles of different economic sectors; 2) altered the opportunity structure for large and small enterprises; and 3) transformed the inputs of labor and capital."

The authoritarian government of Taiwan was fairly stable until the death of Chiang Kai-shek in 1972. Chiang Kai-Shek was succeeded by his son who initiated a major reform movement to clean-up the government. He set up limits on spending for officials, reduced the amount of corruption and campaigned actively for an honest and efficient government. During this period, the government also developed a crucial focus, the focus on technology and improved infrastructure.

In 1982, the government introduced a four-year plan, "new guiding principles" that included economic liberalization and internationalization. These changes have caused many to consider Taiwan in a "new-developmental state." Democratization leads us to where Taiwan is today.

The central government is organized under the Constitution of the Republic of China, which was adopted in 1947. The government consists of the National Assembly and a government composed of five independent branches, called Yuan. These branches are the Executive, Legislative, Judicial, Examination and Control. Of these five Yuan, the Executive is the highest in rank and is headed by the Premier. The National Assembly’s primary purpose is to elect the President and Vice President. Since January 1988, Lee Teng Hui has served as President of Taiwan. However, he was defeated on March 18^th 2000 by Chen Shui-bian. Historically, the Executive Yuan has wielded the most power, but its dualist power-sharing relationship with the presidency has become more ambiguous in the 1990’s. Ultimately, the Executive and Legislative Yuan control the financial system. The Executive Yuan initiates legislation, and then the Legislative Yuan passes it to law and delegates its power to other ministries.

The Executive Yuan is divided into eight ministries, four of which have regulatory control over financial markets. The Ministry of Finance maintains direct control over financial markets and institutions. The Ministry of Economic Affairs enforces the Company Law and the Statute for Investment by Foreign Nationals (SIFN). The Ministry of Communications is responsible for the postal system, which is a domestic player in the financial intermediary sector. Finally, the Council for Economic Planning and Development monitors international economic trends.

The Ministry of Finance (MOF) has the overall responsibility for matters relating to foreign exchange administration. The MOF regulates commercial and other banking institutions through the Bureau of Monetary Affairs (BOMA); supervises insurance companies through the Insurance Department(ID); and regulates the securities market through the Securities and Exchange Commission(SEC).

Implementing financial regulations through the MOF requires the coordination amongst the BOMA, ID and SEC. However, the coordination and separation of powers amongst the departments results in confusion and bureaucracy. In addition, the convergence amongst banking, insurance and the securities markets adds to the overlap, confusion and turf wars. MOF officials often are rotated to head state-owned banks and insurance companies, creating conflicts of interest.

The SEC was first established in September 1960 as the main regulator of Taiwan’s security markets. The SEC consists of two full time commissioners and five part time commissioners from the Ministry of Finance, Ministry of Economic Affairs, Ministry of Justice, the Council for Economic Planning and the Central Bank of China (CBC). As the main supervisor over the securities markets, the SEC supervises public offerings, approved brokers, the Over the Counter Market, and the Securities Dealers Association. However, the SEC lacks prosecutorial authority and must rely on the Ministry of Justice (MOJ) to enforce regulations.

The SEC does not hold as much power as the SEC in the United States. The primary power in creating and interpreting regulations remains in the MOF. Some securities businesses are also subject to rules adopted by the Executive Yuan. The chairman of the SEC is accountable to the minister and three vice-ministers of the MOF, which is then accountable to the Executive Yuan, which is accountable to the Legislative Yuan. The Legislative Yuan is subject to the impeachment powers of the Control and Judicial Yuan. The interconnectivity of the powers entangles the SEC and MOF in political struggles. The power is further diluted by the control of the CBC with regard to foreign exchange issues.

Taipei is the provisional seat of the central government. Under the aegis of the central government are the Taiwan Provincial Government, the Taipei Municipal Government, the Kaohsiung Municipal Government, as well as the various county and municipal governments. Political representatives at the provincial, county and municipal level are elected by the people. The provincial government operates almost parallel to the central government, creating a complex administrative system. There is a long-standing lack of clarity in the authority of the different levels of government. This affects the financial regulation of local financial institutions and results in dual and sometimes inconsistent financial regulation.

The basic laws of Taiwan are influenced by the continental European system, in particular the Civil Code. Therefore, laws are judge made, and attorneys have a smaller role than in the United States. However, present commercial and political legislation has been influenced by existing laws of both the United States and Europe.

Following the end of World War II, Taiwan took control of existing financial institutions established during the Japanese occupation. In 1946, the then Bank of Taiwan official issued the Taiwan Dollar as a symbol of independent sovereignty. Two years later, the Central Bank of China (CBC) was established as the official Central Bank. Under the Control of the Executive Yuan, the CBC was given the power to issue national currency, determine monetary policy, manage monetary reserves, and regulate the banking system. More importantly, the CBC was given the power to serve as the lender of last resort to domestic financial institutions.

Before 1987, the monetary policy of the CBC was dictated by the maintenance of a fixed exchange rate system. Currently, the CBC regulates the monetary supply by regulating the percentage of reserves that banks must maintain against deposits and has overall control of all foreign currency exchange. Taiwan has a long-standing policy bias in favor of domestic borrowings, which has resulted in a largely undeveloped debt market. The CBC maintains its independence from the Central Government, but it reports to the Executive Yuan, which nominates the bank’s board of directors. The CBC has maintained a long track record of prudent monetary policy with inflation and currency depreciation kept in check. The CBC also plays a vital role in the financial markets through open market operations to buy and sell domestic government bonds.

After World War II, five states owned banks moved to Taipei from Mainland China. The five banks consisted of the Bank of Taiwan, an agriculture bank, an industrial finance bank, a foreign exchange bank, and a foreign trade-financing bank. The passage of the Banking Law provided the formation of several different types of financial institutions. Consequently, the banking system developed to include commercial banks, savings banks, specialized banks, investment companies, and other non-financial institutions including the postal savings system and insurance companies.

During the period of 1950 –1965, Taiwan experienced rapid economic expansion. In order to keep up with the expansion, the government allowed new financial intermediaries to compete with the state owned banks. These included privately owned national banks, such as the Farmers Bank of China, Overseas Chinese Banks, and the first foreign bank branch, Kargyo Bank of Japan in 1958.

In 1985, the Central Deposit Insurance Corporation (CDIC) was established as part of the Deposit Insurance Act. Financial Institutions were allowed to enter insurance contracts with the CDIC, similar to the FDIC in the United States. The CDIC is part of the Ministry of Finance and has full power to suspend or close failing institutions.

The banking industry in Taiwan remained predominately state owned until the Banking Law was amended in 1990. De-regulation allowed private banks to compete with state owned banks, and more importantly, it provided a means for entry of foreign banks. As part of the Amendments, Taiwan followed the German model of banking by allowing financial intermediaries the powers of both commercial banking and investment company activities. These included taking deposits, making loans, brokering, underwriting, and investing securities. Additionally, foreign banks could also engage in commercial banking activities and act as agents in securities issuance, manage mutual funds and provide consulting services in marketing securities.

In September 1994, the MOF removed the restriction on the number of foreign banks allowed to set up branches in Taiwan each year. These branches were not allowed to extend loans, offer checking accounts, demand deposits, time deposits and savings accounts. However, they were allowed to engage in foreign exchange transactions and short-term bills operation. In addition limitations on the total amount of New Taiwan dollar credit extended to each customer were established.

Offshore banking units could now invest in foreign mutual funds and convertible corporate bonds; issue, notify and negotiate foreign currency letters of credit; provide foreign currency guarantees; undertake the discount and acceptance of foreign currency bills and notes; as well as provide offshore customers with new financial products, including foreign currency margin trading, interest rate swaps, forward rate agreements, options and financial futures.

Generally, offshore banking units are free from foreign exchange regulations and exempt from Taiwan taxes such as the stamp tax, VAT and certain income tax. However, any transactions involving exchange of New Taiwan dollars for foreign dollars requires prior approval from the CBC.

Liberalization since the late 1980’s has fostered dramatic growth in the number of financial institutions. The number of domestic banks has increased from 16 in 1990 to 45 in 1999. Not surprisingly, Taiwan is generally considered to be "overbanked." There are currently approximately 500 different financial institutions ranging from full license domestic banks, credit cooperatives, and bill finance companies. Taiwanese financial system’s vulnerability lies not in credit growth or reliance on external funding, but rather from liberalization before the sector had sufficient monitoring tools. Furthermore, the financial sector is sheltered from competition from foreign banks or a developed domestic capital market. The CBC, MOF and CDIC are all understaffed. New legislation is being drafted to enhance supervision and regulation.

A unique aspect of Taiwan’s financial intermediary system is the presence of non-traditional financial intermediaries such as the Postal Savings System, which serves as a major competitor of domestic banks. It offers life insurance and collects savings deposits. The Postal System takes private savings deposits and transfers them via the Central Bank to various public entities to strengthen the national infrastructure.

In addition, insurance companies act as institutional investors to compete with financial institutions. In 1987, the Ministry of Finance allowed some United States Insurance companies to enter the market. Then in 1992, the Insurance Law was amended as Taiwan moved in line with GATT. Foreign companies were allowed entry via joint ventures with local firms, and later the Ministry of Finance allowed foreign insurance companies to open branches in Taiwan. As part of the Amendments, insurance companies could invest in public bonds, private debt, approved public stocks and bonds, and mutual funds issued by domestic Securities Investment Trust Enterprises.

A stable currency as a store of value is crucial to the development of an efficient banking system. Taiwan has a long track record of keeping its currency depreciation constantly held in check. After World War II, Taiwan implemented strict foreign exchange regulations on export acquisitions to accumulate foreign currency reserves. In 1949, the newly issued Taiwan Dollar was pegged to the United States dollar at an exchange rate of $1 to NT$5.

A system of Exchange Settlement Certificates (ESCs) was also established along with a pegged currency. Under this system, all money earned by exports was sold to CBC. Twenty percent of the NT$ were sold at the official rate (5 to $1), and ESCs were issued for the remaining eighty percent. ESC were freely negotiable on market or sold to CBC at an official rate.

A series of cautious devaluation by the CBC led to the adaptation of a multiple exchange rate system in 1949. Different exchange rates were used for different exports/imports. In 1958, the system was revised from ten exchange rates to only two. Finally three years later a unitary exchange rate was again established. During 1970, the Statute of FX Regulation obligated the CBC to maintain the fixed rate to the dollar. Two years later a Forward Market was established to the British Pound, Swiss Franc and Deutsche Mark.

In 1978, the CBC relinquished its obligation to maintain a fixed rate, and five state banks established the Center for Foreign Exchange Transactions. The Center served as the only broker for foreign exchange and set the fixed rate daily. Inflationary pressure led to the allowance of transactions over $30,000 to be freely negotiated in 1989. Then a year later, banks in all customer transactions could freely get their own rate. Today, the degree of internationalization of Taiwan’s capital markets is determined by the foreign exchange controls under the Statute for Administration of Foreign Exchange (SAFE) executed by the CBC. The CBC, CEPD and MOF agreed in 1995 to gradually relax foreign exchange controls under SAFE to be lifted completely by the end of 2000.

During the occupation by Japan, no official stock market existed, but Japanese brokers sold Japanese shares to domestic investors. Then in 1949, the newly formed Republic of China issued its first security, the Patriotic Bond. In 1953, the "Land to Tillers’ Program ultimately paved the way for an over the counter market (OTC). The objective of the program was to expropriate the land from large landowners and redistribute the land to farmers. In exchange for their land, the owners were compensated with bonds and equity shares of four states owned companies. Unaccustomed to securities, landowners were reluctant to hold their shares, and the OTC developed. Private companies served as brokers and bought the landowners shares for cash. In 1955, the government required brokers to register with the Ministry of Finance.

After the creation of the SEC in 1960, the Taiwan Stock Exchange (TSE) was officially established in October of the following year. The government required mandatory listing in the TSE of all securities traded on OTC. Selling TSE listed securities on OTC was outlawed. Inititially, the market developed slowly with only eighteen register companies with a market capitalization of $NT 5.4 billion on the TSE, in 1962.

The TSE was designed similarly to the New York Stock Exchange. The Taiwan Stock Exchange Corporation governed all listings, set broker commission rates, established discipline, and set opening and closing hours. The Corporation officially opened on February 9, 1962 with paid in capital of NT$ 10 million. In 1968, the SEC established the regulatory framework for issuance of securities and the TSE. The TSE is self-regulated under the Securities Exchange Law, but as a government-owned business corporation, it is susceptible to political control by the MOF, EY and the ruling party. An agency problem persists in that because securities firms do not own the TSE, TSE’s goals can be at odds with those of securities firms.

In 1974, three state-owned banks established a margin system, which was replaced in 1980 by Fuh Hwa. Fuh Hwa was granted a monopoly over all margin purchases and short sales by the government. Any individual investor could open a broker account, but in order to open a margin account with Fuh Hwa, investors needed to establish a six-month track record. Then, Fuh Hwa provided funds and securities for short selling and margin purchases.

In 1976, a money market was created that included Commercial Paper, Banker’s Acceptance, Trade Acceptance, Negotiable CDs, and T-Bills. Three finance companies were granted permission to serve as financial intermediaries in the money market. However, the Ministry of Finance ended this oligopoly in 1992, as banks were now allowed to underwrite in the money market.

Growth in the financial markets remained slow as regulations and a lack of product breadth stymied market potential. Consequently, during the eighties, the Executive Yuan set out to modernize its financial markets. Milestones include the re-establishment of the OTC market in 1982. The following year, the Executive Yuan introduced a plan for Overseas Chinese and Foreign Investment in Securities. Stage 1 allowed foreign capital into Taiwan Securities market via Securities Investment Trust Enterprises (SITEs). SITEs were allowed to issue and offer mutual funds of domestic securities to offshore investors. During the mid-eighties, three additional SITEs offered beneficial certificates to investors in London and New York, which raised over $150 million in both markets. By the end of 1991, twenty-eight Mutual Funds were offered by SITEs, eighteen of which invested over $80 billion in the TSE.

As part of Stage 2 of the Plan, the SEC allowed foreign representative offices to act as broker dealers in the domestic market. In 1991, Merrill Lynch and Shearson Lehman opened branch offices in Taipei. Two years later, the SEC allowed established foreign branches full power to underwrite, deal and broker securities. Additionally, they allowed new foreign firms to enter via joint ventures with local firms. However, all firms were still subject to the requirement of the Securities Exchange Law. Therefore, approved broker dealers had to meet minimum capital requirements, and post a performance bond with the SEC.

Originally the SEC prohibited majority foreign ownership in SITEs, but in 1996, foreign ownership restrictions for foreign financial institutions with pre-established track records were removed. At the end of 1995, there were 65 open-ended mutual funds approved by the SEC, nine of which were raised overseas and had a total NAV of NT$52.6 billion. The remaining 56 were raised from domestic investors and had a total NAV of NT$103.6 billion. There were also 17 closed-end mutual funds, which had a total NAV of NT$84.6 billion at the end of 1995. Eight open-end mutual funds invested in overseas securities, with a total NAV of NT$5.8 billion. The SEC continues to tightly control portfolio strategies due to concern that investment in money-market funds will cause the CBC to lose further control over the money supply, a move that authorities are unwilling to make

By the mid-nineties, traditional volume in the Taiwan financial markets rivaled Tokyo, New York and London. However, extreme volatility resembled markets in developing nations. Despite the Executive Yuan’s efforts to modernize, the capital system in Taiwan still suffered from few means to hedge risk, a limited amount of investment products, and a lack of Institutional Investors. In order to combat these issues, the government enacted a series of measures. The Foreign Futures Trading Law (effective January 10, 1993) was adopted, followed by the Futures Trading Law in 1997 with the goal of developing a domestic futures exchange. Anticipated future reforms include revision of SEL to permit a local futures market for trading securities-derivative futures.

In 1994, the SEC granted licenses to nine foreign futures trading companies. Additionally, the Ministry of Finance allowed foreign companies to issue Taiwan Depositary Receipts (TDRs) on the Taiwan Stock Exchange. The Executive Yuan also allowed qualified foreign institutional investors (QFII’s) to invest in the TSE, but placed a cumulative ceiling on the amount of investment. QFII’s are subject to an individual company investment quota of 10% and a total market investment quota of 25%.

Increasing the representation of institutional investors in the capital markets became an important goal of the Executive Yuan’s plan as Institutional Investors were viewed as a stabilizing influence on the economy. The SEL authorized the formation of Securities Investment Consulting Enterprises (SICE) to advise clients. By 1990, many foreign SICEs were established including Fidelity, Citicorp, and Jardine Fleming. Unfortunately, so far, SICEs are severely regulated to the point that they perform primarily as a research function. Additionally, the regulatory framework is unclear. For example, the SEC allows the SICEs to promote foreign mutual funds with SEC registration and approval. At the same time, trust departments of state-owned banks were allowed to offer nondiscretionary trusts, which could invest primarily in foreign mutual funds without much regulation. The SEC has not allowed SICEs to engage in general asset management, only "advice." This is true even though SITE’s can manage mutual funds. In 1996, a Trust Law was enacted to provide a general vehicle for asset management. So far, no commensurate tax law or rulings were developed to make the Trust Law practicable. Mutual funds and asset management remains generally unavailable to the growing number of affluent Taiwanese citizens.

Several problems continue to inhibit the growth of the SICEs:

1. The scope of the SICEs permitted business is unclear.
2. SICEs are not allowed to establish branches, greatly reducing the potential size of the SICE client base and efficiency of product delivery.
3. Unlike domestic funds, SICEs are not allowed to advertise offshore funds in a product-specific manner.
4. The SICE application process is administered inconsistently.
5. The offshore fund registration process is subject to severe delays and results in a long waitlist.
6. A fund must be registered by each SICE that advises on it leading to repetitive applications and bureaucracy.
7. Funds must establish a two-year performance history before being considered for registration.

In addition to SICEs, the pension fund was created to increase the amount of institutional investment. The Central Trust Bureau of China manages the fund under the supervision of the government. The pension is contributed by enterprises covered by the Labor Standards Law. The fund is allowed to invest in bills, bonds, listed stocks and beneficiary certificates issued by securities investment trust fund enterprises. Pension funds are allowed to invest a maximum of 20% of net fund balance in listed stock and beneficiary certificates.

Finally, foreigner investors are allowed to invest in the local securities market via:

While the Company Law prevails over Taiwan enterprises, the SEC prescribes a minimum capital level before a company is required to make a public offering. Once a firm meets that minimum level, the company becomes subject to SEC. Consequently, public companies are subject to both the Company Law and Securities and Exchange Law (SEL). SEL provides regulation and supervision for issuing and trading securities. However, Taiwan has a major presence of narrowly owned companies (shares vested in small group of shareholders including founders, current owners, management, and the government). On the one hand, the existence of these companies prevented the TSE from having large public float, which increased volatility in the secondary market. On the other hand, a network of rural based family managed firms evolved via specialization and flexibility that created extremely efficient organizations.

Traditionally, Taiwanese firms relied on short-term borrowing. However there are many sources of funds available to domestic enterprises including: loans from banks, the underground market, households, and government agencies; as well as foreign capital markets, money market securities, corporate bonds, and post dated cheques. Before 1993, a major source of short-term working capital was postdated cheques. Traditional businesses requiring Short term financing issued post dated cheques to suppliers of goods and services. These cheques either sold at discount to banks or were held to maturity. For the Year ended 1992, small and medium sized firms uses postdated cheques for 38% of their financing. In contrast, they used banks for only 37% of their financing. The absence of a developed bond market also increased the reliance on short-term borrowing.

In addition, Taiwan firms were predominately traditional Chinese family businesses. These businesses operated on a small scale, centralized decision making, and relied on a network of kin and friends for labor and capital. They failed to create large-scale market recognition. Conversely, many conglomerates emerged on the corporate environment including the Tatung Group with 31 firms in electronics and machinery. The conglomerates are similar to the old Japanese Keiretsu, which were motivated by the rule of opportunistic diversification. The ownership structure tended to be a mix of business and government ownership. For example, the KMT Business Group, which owned a stake in Fuh Hwa, is partially owned by the former ruling political party, Kuomingtang.

Taiwan’s government has stated its intention to adopt an aggressive privatization program as a prelude to liberalization to join the WTO. So far, US$8 billion has been made from the sale of 16 enterprises since the early 1990’s. However, there have been schedule overruns, labor union protests and legislative delays. The privatization effort points to Taiwan’s overall commitment to economic liberalization, but have few direct effects on the regulation of the financial markets.

Taiwan has officially announced a desire to establish incentives for establishing Taipei as an international financial center for the Asia-Pacific zone. However, none have been legislated yet. Generally speaking, the regulatory environment for foreign investment has become progressively more relaxed. The securities market, however, remains a restricted (but not prohibited) industry sector and lags other sectors in the relaxation of regulatory constraints.

The Taiwanese government has developed six strategies for developing Taipei into a financial center. As announced in 1996, the strategies were as follows:

1. Target year 2000 for achieving financial liberalization. Remove restrictions on inward and outward capital flows in order to achieve "full liberalization of offshore operations and gradual deregulation of the domestic market."
2. Compete with Tokyo, Hong Kong, Singapore and Shanghai, among others, to develop Taipei as another financial center emphasizing capital funding and asset management. Taipei will promote its complementarily in order to promote regional prosperity.
3. Upgrade the efficiency and transparency of the financial system by separating operational functions from supervisory functions. Replace the existing review system with customer-oriented reporting.
4. Enlarge the depth and breadth of the capital market. The futures market was scheduled to be open in 1997. Make information transfer in the capital market more efficient and less expensive.
5. Refine financial regulations to bring them into conformity with international standards.
6. Continue to adopt a more flexible way to promote financial exchanges with Mainland China. An example is, beginning in July 1996, local securities firms were able to establish subsidiaries, invest in securities, and deal in brokerage and underwriting businesses on the Chinese mainland.

As China surprised the world with continuous high economic growth and has drawn more and more attention from all over the world, signs calling for further political, legal and financial reform of the current regime are also mounting. Declining exports, stalling growth of FDI, a growing debt to GDP ratio, slowing domestic consumption, excess workers, capacity and inventories may hamper the growth that China needs to truly become a modern industrial superpower.

The financial market has undergone substantial development in the past ten years. However, the industry remains substantially State regulated and controlled. As one of the largest and the fastest growing economy in the world, China has seen the problem that investment required to sustain the economic growth has outpaced the traditional sources of financing (i.e., the state budget, bank loans, and foreign direct investment.).

A major challenge to China is to obtain the funding it desperately needs for infrastructure development. The World Bank estimates China would need between $70 to $80 billion, which will need to come from foreign as well as domestic resources. Equities remain an underutilized source of capital for enterprises in China, and as such represent attractive future sources of financing. The successful use of equities by the four little dragons, South Korea, Hong Kong, Taiwan and Singapore, provides a carrot to China. Taiwan, which outperformed the S&P 500 during 1984-1989, provides the most robust model for China’s financial reform. Economic evidence has also proved that open markets for financial services translate to higher national income.

Given the context of the recent World Trade Organization negotiations, China has an unprecedented opportunity to push through financial reform, reform that can help China complete her transformation into a modern industrial superpower.

The current political and economy structure of China took its shape in 1949 when the government of People’s Republic of China was formed. When leadership changed from Mao to Deng Xiaoping in late 1970s, China moved from communism to "socialism with Chinese characteristics."

China transformed from a closed, small-scale agriculture-based economy to a more open economy based on industrial production. Unlike Taiwan, which began its privatization efforts in the 50’s, between 1949 and 1978, private enterprise was virtually non-existent in China.

The government controlled the economy by allocating resources, planning demand and supply for all industries among enterprises, setting prices for all products (including workers’ salary) and providing lifetime employment for essentially every urban resident. The government selected the management of companies. Since supply, demand, and prices were fixed, little competition existed. Management of companies, as the agencies, had little incentive to improve company efficiency due to the inflexibility on production and products. These government regulations stifled entrepreneurial incentives.

In the two decades since 1978, China has transformed itself from a centrally planned economy to an emerging market economy and at the same time has achieved nearly a 10 percent average growth rate. During this period, China’s per capita GDP has more than quadrupled and the living standard of ordinary Chinese people has improved significantly. China’s transition was a two-stage process.

In the second stage, corresponding to the fifteen years between 1978 and 1993, the old system was reformed to improve incentives, harden budget constraints, and create competition. Some of the institutional fundamentals in this stage included regional decentralization of government, entry and expansion of non-state enterprises and a dual-track approach to market liberalization.

Post-1994, the third stage, China has set a goal of replacing the planned system with a rule-based market system. Monetary reforms included unifying the foreign exchange market and making the current account convertible. The tax and fiscal systems were also overhauled to create stronger accordance with international practice. Banking reform included centralizing the central bank operation, downsizing government bureaucracy and forcing the military to give up commercial operations.

Additional capitalistic reforms included the move to privatize state-owned enterprises and lay off their workers. Before 1978, 78% of national industrial output came from state-owned enterprises. By 1993, State owned enterprises only contributed 43% of the total national industrial output. Today, an estimated 10-15% of SOE’s has been divested leaving a total of 300,000 state enterprises. Similar to Japan’s keiretsu, the Chinese government has identified one thousand key strategic enterprises of which it plans to retail full control.

China’s financial system is largely state regulated and controlled. However, the fast economic growth has pressed the government for a financial market that can provides a wider array of options for diversifying risk, higher rates of return, a larger pool of investment funds and an opportunity for cheaper financing through access to foreign capital markets.

Prior to 1979, China operated a mono-bank system with no-interest-bearing loans. In essence, banks’ primary function was to dispense government grants. 1984 marked the pivotal moment when the mono-bank discarded commercial lending practices and became a central bank, a move that decentralized the banking system and encouraged competition. Before 1994, 70% of the central bank’s loans to state banks were made by the central bank’s local branches, which were heavily influenced by the local governments. In 1995, China passed the "Central Bank Law" to give the central bank the mandate for monetary policy independent of the local government. In 1998, the central bank further replaced it 30 provincial branches with nine cross-province regional branches as in the US Federal Reserve System. Following Taiwan’s model, this reform continued to minimize the local governments’ influence on monetary policies.

Since 1994, limited progress has been made tin commercializing the four major state banks. These banks began to adopt the international accounting standard for bank assets and risk management, and became more conscious of profitability and the quality of loans. Reform fostered additional competition among the banks. Starting in 1998, the central bank abandoned the credit allocation ceilings imposed on these banks, replacing them with standard reserve requirements, asset-liability management, and interest rate regulations. At the same time, foreign banks were allowed to open branches in China. However these branches are restricted to dealing with foreign currency and deal primarily with international settlement.

In its financial reform, China has followed a US model of banking regulations along the lines of the Glass-Steagall Act; commercial banking is separated from investment banking and commercial banks cannot hold shares of stocks in companies. Before 1998, the state always bailed out troubled financial institutions, but for the first time in 1998, several high profile banks and investment companies, such as Hainan Development Bank and Guangdong International Trust Investment Company, closed down or went bankrupt. This signaled that the government was determined to discipline state financial institutions and gives the reform greater long-term credibility.

China has undertaken very conservative monetary policy. China’s conservatism has served well in managing its external debt. Internally, China does not have a credit system. It remains a cash-based society; even large-scale deals are often conducted in cash. Credit plan is the primary monetary policy instrument.

China suffers from an uneven distribution of resources and economic development. Four state-owned banks still control 80% of the market while the eleven commercial banks have no official lending requirements. Due to the threats of widespread unemployment, State banks continue to allocate credit base on the central plan and extend loans to highly inefficient SOEs. Under this policy, huge non-performing loans have been accumulated on State banks’ balance sheet, which has in turn distorted the allocation of capital. Policy-loans and loss-subsidies now account for as high as 10% GDP and lending to the private sector has been crowded out.

The need to overhaul the banking system is increasingly apparent. Since 1990, loans have exceeded deposits. Loans are often used to pay-off non-output related activities (i.e., wages and previous debts). Bad debt is estimated to account for as high as 20% of banks’ portfolios. The bad debt levels lead to negative interest rates. As SOEs are becoming more indebted, on average they are not able to cover all their costs with their revenue. Asset management companies have been created to deal with non-performing loans at state-commercial banks. The debt-serving burden of non-performing loans makes it difficult for Chinese banks to compete with foreign banks. The single most pressing issue in central banking reform is arguably to help banks reform quickly enough so that the non-performing part of their portfolios do not rise to a point which collapses the entire banking system.

In the mean time, the over-extension of domestic loans to SOEs has rapidly expanded the money supply and threatens inflation. The stock of money supply (M2) has become large in relation to GDP, while the velocity of money has been declining. This growth in money supply potentially exceeds the real growth in the economy. Interest rates have remained under government control. In 1994, laws were passed to create a more transparent tax system and to reverse steady declines in fiscal revenues. At the end of 1996, the IMF declared that China had reached full convertibility on the current account. China is the only East Asian country that still has a closed capital account. Although convertibility on the capital goal is a future goal, concerns about SOE bankruptcy and capital flight have hindered any real reform in this area. Arguably, convertibility cannot become a realistic goal until prices stabilize, and a stronger financial framework is developed.

In 1990, China became the first communist nation to have stock exchanges. To date, this market is still highly state controlled. Exchanges have been established in Shanghai and Shenzen. China currently has 1,000 companies listed on domestic and international markets. As of January 1999, the Chinese securities market was comprised of 862 firms with a market capitalization of $232 billion. Of these 862 firms, only 107 firms offer B-shares. Forty-three firms issued H-shares. Twenty-three foreign brokers have seats on the Shanghai exchange and eight on the Shenzhen. The major players within the Chinese securities market include China Securities Co. (Huaxis) in Beijing, Guotai Securities Corporation Limited in Shanghai, and China Southern Securities (Nanfang) in Shenzhen.

The Chinese securities market is comprised of three types of shares: state, legal and public. However, only public shares can be traded. The government holds approximately 70% of all equity outstanding in China’s listed firms. Less than 33% of listed companies’ shares are traded. The current system appears to have been designed more to encourage stability opposed to promoting efficiency. Within this market, holders currently have little to no incentive to sell. The Chinese stock market appears to be more speculative than investment driven. This speculative mentality has contributed to a market 800 times more volatile than the NYSE.

The design of Chinese markets has created a situation where demand currently exceeds supply in the A-share market because too many dollars are chasing a limited number of shares. Empirical evidence suggests that A-shares are riskier than B-shares. Better information appears to be available for companies with B-shares. Unlike in other international markets, such as Sweden, foreign B-shares appear do not trade at a premium. In China, B-shares are trading at a 60% discount to A-Shares. This discount may reflect the information asymmetry between domestic and foreign investors. Domestic investors trade heavily on inside information while foreign investors have less information. The discount may also account for the assumed economic and political risk of these investments.

Like Taiwan, the bond market in China is very underdeveloped. Because the coupon rate is set below the coupon rate on government bonds, the non-government bond market has failed to materialize. The coupon rate is set well above fixed deposit rates. Approximately 80% of government bonds are sold to the household sector. Because households tend to hold bonds for their entire duration, liquidity is strained.

The government first began experimenting with selling stocks to the public in 1984. Share trading was legalized in Shanghai in 1990 and Shenzhen in 1991. Foreign shares were first listed as B-shares on Shanghai and Shenzhen in February 1993 while H-shares originated in July 1993. The government controls the listings of new firms and the value of new stock. The government restricts non-state firms from having their shares listed in public exchanges. B-Shares are restricted to limited liability shareholding companies that have been profitable for at least two years. Firms must possess sufficient foreign exchange revenues to pay dividends and cash bonuses. Financial statement and earnings forecasts are required for three consecutive years and at the time of the listing must have a price-earning ratio of less than 15.

Enterprises requesting a foreign share listing are required to obtain approval from the Ministry of Foreign Trade and Economic Cooperation. China’s restriction of foreign ownership is common in emerging markets, but its restriction of domestic investment is more unusual. The restriction of domestic investment has led to an increasingly inelastic demand for equity. Low interest rates further stimulate interest in capital markets.

Individuals are limited to a maximum of 25% of a firm’s B-Shares and total foreign ownership is limited to 49%. Foreign firms may establish representative offices but not local branches or subsidiaries—all transactions require the partnership of a local broker. Foreign banks are prohibited from selling mutual funds to Chinese citizens or institutions and must obtain government approval to participate in underwriting.

Foreign securities firms are prohibited from introducing new domestic financial products, although they may offer offshore derivatives. However, repatriation of profits requires government approval. Furthermore, Chinese residents may not invest overseas without government approval.

China’s efforts have emphasized state control of the financial markets. However, as in the case of Taiwan, China could benefit from a further opening of markets. Securities markets provide an opportunity to raise capital for investments, enhance the efficiency of state assets and social resources, and reduce the debt-servicing burden. A well-functioning market mobilizes savings deposits through facilitating an increased availability of assets. A well-functioning market will create a higher yield with a lower risk, hence a higher return on savings. In contrast, central planning does not provide the most efficient means to channel funds from savers to borrowers.

Major structural problems of the emerging Chinese security markets include its artificial pricing mechanism, the limited number of listed securities and a lack of modern communication facilities and training. These weaknesses in the current system lead to increases in cost of capital for Chinese firms which, in turn, makes it more difficult for them to compete with foreign firms.

Further opening the financial markets provides a means to develop a private sector safety net to provide for retirement, health care and additional future claims on income. In China, pensions and repayment of banking system represent substantial claims on future income. Pensions have become an increasing financial strain on SOE’s. Despite political objectives of maintaining low levels of unemployment, government revenues have declined. China’s tax share is half that of average developing countries. Burdened with a rapidly aging population of 1.2 billion, China faces an enormous hurdle. Furthermore, the number of elderly is expected to double by 2020. China’s one child policy has created a distortion between generations. China faces a huge un-funded pension liability. Pensions are currently indexed to wages, which is problematic given that wages appear to be growing faster than productivity. The World Bank estimates that wages in China will grow about 7% or less per year. Returns on pension funds will need to meet if not exceed wage growth.

Somewhat alarmingly, between 1993 –1995 rates of return on pension balances were below the inflation rate. China began in 1997 to unify locally administered pension plans into a national model. Beijing plans to assign "social security numbers" to allow workers to change jobs and move cities without losing benefits. The original pension system was established in 1951, but in the early eighties it became evident that a pay-as-you-go policy would not sustain China’s aging population.

The new pension system was launched in 1984 and dramatically reshaped in 1991. The pension is mandatory for all employees and employers. New pension plans are emphasizing savings over entitlement. In 1998, the Ministry of Labor and Social Welfare was established. As of 1998, old retirees still receive full salaries until death, but younger workers must fund own pensions. China is shifting to an investment-based system of individual accounts.

The government is requiring employers to contribute 20% of a company’s total wage bill to retirement funds. Eighty percent of defined contribution must be in bonds while 20% in deposits. Employees and employers must contribute a total of 11% of the workers monthly wage to the pension. The plan covers 96% of SOE’s, 60% collectively owned companies, and over 95% of retirees. A threat to the success of this model is whether these funds will achieve the necessary growth given China’s recent low to negative interest rates. Given that life spans have increased by 10 years since 1970, current retirement ages (60 for men and 55 for women) may need to be raised.

Because of social welfare issues, the government is hesitant to shut down SOE’s. As such, the pension system misallocates capital and labor. SOE’s must devote capital to pension fund management opposed to technological renovation. The pension system also restricts labor movement since workers will lose pensions if they move. Making pensions transferable will create increased labor mobility.

The current pension system is three-pronged: 1) social pooling accounts 2) individual accounts and 3) supplementary accounts. The pension system suffers from lack of unity and overlapping bureaucratic control. Ministry of Labor and social security, State Commission for Economic Restructuring, State Economic Trade Commission, Ministry of Finance, Ministry of Personnel and the Ministry of Civic Affairs all have authority vested in the pension system.

The pension system would benefit from an expansion in investment opportunities. The development of a stable pension system depends on the creation of a modern banking system. The TransAsia Group, a direct investment specialist, estimates that 10,000 Chinese foreign-funded companies have set up supplementary pension and health funds with $2 billion under management.

Before 1994, China’s tax and fiscal system was not rule-based. China did not have a national tax bureau. All taxes were collected by local governments, which often reduced or exempted taxes that were supposed to be paid to the central government. On January 1, 1994, China introduced major tax and fiscal reforms more aligned with international practices. This reform introduced a clear distinction between national and local taxes and established a national tax bureau and local tax bureaus, each responsible for its own tax collections. The reform also established fixed tax rules between national and local governments. In 1995, the new "Budget Law" took effect. It prohibited the central government from borrowing from the central bank and from deficit financing its current account.

Since 1992, China has been the largest developing nation recipient of FDI, and is second only to the US in terms of overall FDI. In 1998, US direct investment is estimated at $6.3 billion. Overseas Chinese play major role in direct foreign investment; Hong Kong, Macau and Taiwan were China’s biggest investors.

China is currently the fourth largest trading partner of the US. More than $85 billion goods were traded in 1998. US trade deficit to China in ’98, $56.9 billion grew to an estimated $66.4 billion in ’99. U.S. International Trade Commission predicts that the accords could lead to an increase of $586 million in the US-China trade deficit. US Trade representative estimated that China’s accession to the WTO could translate to $3.1 billion increase in U.S. exports, a very conservative estimate.

Premier Zhu Rongji has staked his political career on winning China’s entry to WTO. The effort on Chinese government’s part to push through the WTO agreement showed their commitment on China’s reform policy and their determination of replacing the planned system with a market system.

As China’s reform move to this defining stage, the government alone can not overcome the challenges generated from the political and economic regime. Challenges including a fragile banking system that has an increasing amount of non-performing loans in the state banks, difficult privatization of SOEs, and the establishment of the rule of law, have to be addressed and embraced by domestic and foreign investors within the new WTO arena. The Chinese government views entering WTO as a means to overcome internal resistance and to push more capitalistic reform.

Joining WTO should bring improved transparency of trade restrictions. Although Article X of GATT and Articles III and VI of GATS require publication and transparency, China has a weak track record of publishing administrative and judicial decisions. China stopped publishing its five-year plans after 1994. Ministry policies also appear readily unavailable. Blocked access to information can act as a barrier to trade, furthermore the WTO is not designed to deal with this constraint. The WTO stands to strengthen rule of law in China. As US trade representative, Charlene Barshefsky, assessed:

The World Trade Organization provides a strong opportunity for the financial services markets. The agreement offers U.S. banks some access to a market that is 1.1 trillion yuan ($132.88 billion) in size. With rules changes that would take place in the next two to five years, U.S. banks for the first time in history would be able to manage deposits of Chinese citizens and make loans to individual and corporations. U.S. security firms would be able to franchise its investment banking expertise in China in the near future and benefits from faster growth in the telecommunication and energy industries.

WTO led reforms within the financial services market also include allowing banks to do business in local currency for businesses within two years and for consumers in five years. Geographic and customer restrictions will be eliminated. Foreigners would be allowed to own 33% of fund management companies increasing to 49% in three years. Underwriting stake will be limited to 33%.

"The business community sees WTO opening a whole range of markets in China that are not open today." Said Maurice R. "Hank" Greenberg, the chairman of AIG. In order to join WTO, China must open markets as well as honor CopyRight law. Under the most recent plan, China agreed to slash tariffs on agricultural and industrial goods and open its telecommunications. Within the telecommunications market foreigners may own 49% stake that will be allowed to grow to 50% within two years of China’s entry into the WTO.

China wants the US to give it a permanent "most favored nation" status. Since 1974, status has been granted on an annual basis. American business groups have raised an estimated $10 million for lobbying Congress on this issue. Leading political candidates from both parties in the US appear to favor the agreement. Opposition to the deal includes labor unions and representatives of textile producing states. In addition, China must complete negotiations with the European Union with additional demands include access to the insurance market and cutting additional tariffs on cosmetics and agricultural machinery. Growing tension about reunification with Taiwan heightened during Taiwan’s election period but appears to have subsided with a new less antagonistic positioning emerging from Taiwan’s new government.

Joining WTO should also have positive impact on corporate governance. Corporate governance has been a dominant policy issue in developed economies for more than a decade. In the transition economies, it took some time for corporate governance to move up in priority. It is an issue concerning the interaction between law and finance and the role of institutions in economic development.

China has very poor corporate governance derived in part from the fiduciary conflict with agencies acting as shareholders and administrators. Corporate governance evolution will depend upon China’s ability to address tax and fiscal policy, adverse selection, and lack of competition.

Joining the WTO not only fosters positive development within the financial and judicial systems, but also creates a healthy environment for the formation of an institutional foundation of China’s economy. Efficiency of the financial market would also be greatly improved due to increased competition that brought by foreign investment. Changes in the financial, legal system and institutional structure will improve corporate governance, the capstone to China’s success.

3. MOVING INTO THE 21^st CENTURY

While the Taiwanese government has publicly stated its goal of increasing the presence of foreign institutional investors, the current investment restrictions in Taiwan make it difficult for foreign investment companies to buy and sell stocks on the TSE. Additionally, current market regulations do not accommodate dissatisfied owners. Foreign investors are required to move their money into Taiwan and convert it to New Taiwan Dollars before investors can decide which companies to invest in. After selling securities, investors must reinvest their money in another Taiwan company within a matter of months or lose the right to invest that money in Taiwan. Consequently, most foreign institutional investors find there are too many restrictions to invest in Taiwan. Others complain that the approval process remains "cumbersome and is never automatic."

However in defense of Taiwan’s policies, the regulatory and capital market structure of Taiwan enabled the country to survive the Asian crisis virtually unscathed. Taiwan was not burdened by vast amounts of foreign debt like other countries in the region. Additionally, the corporate landscape of Taiwan dominated by tens of thousands of small to medium sized enterprises (SMEs), provided a dynamic and flexible export led productive sector. The SMEs represented over eighty percent of Taiwan businesses, and their size allowed the SMEs to adjust their production and marketing strategies to rapidly changing market conditions.

In the aftermath of the crisis one thing that remains clear, Western Institutions can not force fit Western management theories to traditional Chinese businesses. They need to understand the traditional importance Chinese businesses place on family, government, and networks. However, in the aftermath of the Asian financial crisis, Chinese companies must learn to place more emphasis on disclosure and corporate governance in order to join the global market place.

The Asian crisis gave the world a careful reminder that countries that open themselves up to capital inflows are more vulnerable to large capital outflows when investor sentiment turns sour. South East Asian countries such as Indonesia, Malaysia, the Philippines, and Thailand were hit the hardest. Capital outflows in these countries led to sharp currency depreciation and severe recessions, while Taiwan maintained its current capital restrictions and weathered the storm. However, according to the OECD Observer, evidence shows that mature market efficiency from capital liberalization far outweighs the risks of capital flight. There are no developed OCED nations that maintain capital controls, even in the short-term. On average, these nations benefit from an annual gain from the mobility of international capital that equals approximately one percent of their GDP.

The key is to reduce the risks associated with capital liberalization. This is accomplished with strong corporate governance and market discipline via transparency and uniform disclosure. In most OCED countries, foreign investment is crucial to sustain the liberalization process. Sophisticated foreign investors, especially institutional investors, are not willing to take long-term commitments unless they have the opportunity to exert influence in a market that will accommodate dissatisfied owners. The presence of foreign capital in the TSE has the potential to enhance local corporate governance and influential investors can help export-oriented local companies to develop corporate financial structures to cope with free capital flows.

In order to attract the largest foreign institutional investors, local companies must instill confidence in the market. Local companies should take the lead in disclosing more financial information to enable long-term investors to make sound investment decisions. Another problem occurs when companies group their businesses and minority stakes together, which makes it difficult for investors to distinguish the lines of profitability. Uniform reporting and disclosure requirements should be supported by the regulatory and administrative system.

The main argument against liberalization is the fear of capital flight in times of crisis or fickle changes in investor perceptions. However, the largest investments made by US investors outside the United States are pension funds and large institutional investors. In the US, the 25 largest pension funds invested more than forty-two percent of all foreign investments made by US investors. So called "momentum traders" do exist in the US market, but they are overshadowed by the major public pension funds that actually trade the least. These larger US pension funds tend to be more selective in which companies to invest, use stable, long-term investment capital, and have low turnover even in times of general volatility. Consequently, the capital flight argument is shaky at best.

Another lesson learned from the Asian financial crisis was that liberalization policies in themselves were not the cause of the crisis. According to the OECD Observer, liberalization is defined as residents and non-residents being allowed to transact freely with one another. Ad hoc and discretionary liberal policies almost inevitably give rise to favoritism and corruption and give the perception that the local government is sharing the risk, which can lead to excessive capital inflow from speculators. Corruption, collusion, and nepotism were a main cause of the crisis in South East Asia. In the United States following the Great Depression, the regulatory framework was reformed to decrease the reliance on relationship-based finance, which paved the way for a modern financial system. Consequently, Taiwan can follow this example and use the Asian financial crisis as a catalyst to capital market reform and liberalization policies to keep pace within the global economy.

Based on the experience of other OCED countries, corporate governance improves when the transparency and the extent of disclosure are increased, sizable foreign shareholders are present, and the financial system is private and competitive. Taiwan can attract more stable long-term investment with efficient, fair and predictable legal and regulatory systems that investors can rely on should companies not meet their obligations. Therefore, a capital liberalization policy can increase the amount of foreign institutional investors in the local capital market. Foreign institutional investors can help strengthen corporate governance and market discipline through diversification. Greater transparency and disclosure can strengthen the corporate structure of local export oriented firms in order to compete with firms from other OCED nations. The result will reduce the risks of capital liberalization and solidify Taipei’s position as an international financial center for the Asia-Pacific zone.

In order for a market to be efficient, investors must be willing and able to freely trade shares in the companies. Investors seek companies in which they can understand the information provided, and have faith in the validity of the information, as well as the management of the company. This is true not only of investors but also of trade partners, suppliers and wholesalers of a product’s company – all stakeholders. Monitoring via corporate governance is an effective and proven mode to give investors the comfort they need.

Forms of corporate governance vary in markets around the world, but as markets become more global, governance structures will converge. The two key necessary elements that will lead to this convergence are (1) disclosure and validity of financial information and (2) the availability of avenues to protest decisions made by management not in the interest of the shareholders.

As the Taiwan economy and market becomes increasingly successful and global, it will become important for companies to adopt a form of corporate governance that is acceptable to the investors as well as its export partners in other parts of the world. Below are the corporate governance techniques of the United States, Germany and Singapore, which vary considerably. Taiwan should look at the techniques of these and other countries to determine how to encourage, possibly through regulation, companies to align the interests of their constituencies and monitor the actions of management.

The board of directors, elected by the shareholders, acts as the link between the shareholders who provide the capital and the managers who create the value. In this way the managers benefit from the shareholders’ capital and the shareholders benefit from the expertise of the management to operate and grow the company efficiently. The board’s primary role is to monitor the management on behalf of the shareholders.

In the US, directors are expected to be unbiased monitors of management who scrutinize the operations and choices of management closely. Insiders are defined as board members who are linked to management in more than a monitoring fashion. Typical insiders would include ex-members of management and family members of senior management. Insiders are often accused of favoring the opinions of management over the interests of the shareholders. Several management teams have manipulated compensation packages and made poor corporate investments because they received approval from an Insider board. In these instances an objective board would not have allowed these investments to be made because of the drain on shareholder value. Many investors are wary of boards with large numbers of insiders and investigate boards before deciding to purchase a stock.

Investors typically look for companies who have small boards with industry specialists. These specialists could include ex-senior managers from other similar companies and often university professors who are familiar with the market as whole as well as the financial principles.

In addition, the boards have several imbedded rules that are intended to maintain the link between the shareholders and the board members. These include, the regular election of board members via a proxy vote of shareholders, the right for shareholders and other parties to add resolutions to any proxy to be considered by all shareholders and the right of the board to monitor specific actions more carefully, including compensation and auditing.

In Germany, the board structure is very different, incorporating the employees as a primary stakeholder group. The structure includes a supervisory board, an executive board and a general body meeting of shareholders. The interactions between these boards are similar to those in the US, however; the members of each board are significantly different.

Under German law, half of the supervisory board is elected by the shareholders at the general body meeting and the other half are elected by the employees of the company. The supervisory board then elects the executive board, similar to the senior management group in the US.

The German method of corporate governance links the shareholder, employees and management very closely together, each monitoring the other groups. Uniting the groups behind the success of the company motivates the key constituencies while incorporating the interests of all the stakeholders. However, some critics believe that employees have too much power, and in order for them to have their interests aligned, they should also be equity holders so they are not just interested in wages and general profitability of the company, but are also interested in shareholder wealth.

The Singapore government has structured the governance system very similarly to the US. Boards generally have little to do with the day-to-day operations of the company but are responsible for monitoring the overall health of the company and the decisions of the managers. One primary difference is government involvement. Through holding companies, the Singapore government has considerable equity stakes in most Singapore companies, which gives them the right to a couple of board seats. In this way, the government has influence over the company as a board member, major shareholder and regulator. In the US, the government only acts as a regulator, determining laws and disclosure requirements.

Other than the government participation, the regulations around boards are very similar to those in the US, including:

• The boards are small, consisting of primarily outsiders
• At least one-third of each board must come up for election every year
• The board has the power to appoint committees to monitor specific operations more carefully, including audit, which the government has mandated must be composed of outsiders
• Rights for minority shareholders, including the right to file suit against the management for not making decisions with shareholder wealth in mind and the right to put forward resolutions in the general body meeting of shareholders.

These are key elements of the corporate governance structures in both Singapore and the United States. In Singapore’s attempt to become a "world-class business sector" the government created three committees to find the best practices in use around the world and find the best way to adopt those practices in Singapore. The committees on cooperate governance, disclosure and accounting standards and company legislation and regulatory framework are expected to give reports and recommendations by the end of 2000, and adoption of the recommendations are expected soon thereafter.

Given the current corporate governance structure in Taiwan there are several best-practices in effect in other global markets that should be considered by the Taiwanese regulators. Many of these aspects have already been incorporated with the existing governance structure, but may not be as readily accepted by many corporations.

Focus: Some Approaches to Encouraging Ownership

Encouraging ownership of the company by management and board members is the easiest way to align their interests with those of shareholders. When investors contribute their capital, they are trusting the judgment of both the board of directors and the senior managers. There are several methods that have been implemented to motivate both groups in markets around the world.

Compensating managers and directors with equity is a common way of aligning their interests with the investors. There are two ways of compensating managers, directors and employees via ownership, give them equity shares or give them stock options, both of which have distinct benefits and drawbacks.

Issuing stock to managers as a portion of their compensation motivates managers to make decisions that increase shareholder wealth. If a large portion of their compensation is given via shares, the motivation will include shareholder value in addition to the usual roles of being focused of keeping their job and running a profitable company. Focusing on shareholder value could include actions such as seeking out the most profitable projects and expansion ideas as well as providing information to the market so the share price better reflects the true value of the company.

There are a several drawbacks including diluting the interest of the external shareholders and the judgment of managers. First, by giving management shares as compensation, the balance of power can eventually shift from the outside holders to inside holders without an infusion of actual capital. Indeed the shares are compensating management for their time and effort, but no new cash comes into the company when they are given the shares outright. In addition, the existing shareholders would see their position continually diminish as the senior management gets paid more.

Secondly, as senior management becomes increasingly tied to the stock price they may make decisions to protect wealth in the short term over the long term. If senior management and directors have to watch their net worth fluctuate with the volatility of the stock price, they may not choose to take necessary investments that could have a short-term negative effect, but lead to a long-term negative effect.

Thirdly, by compensating managers and directors with shares, they will be taking on an arguably unduly large amount of risk, the risk of the market. The intention of paying them with shares would be so they are exposed to the non-diversifiable, or firm-specific risk which they in many ways control. However, in each share there is an element of diversifiable risk, the risk of the market that comes with the non-diversifiable risk.

Issuing stock options to managers as part of their compensation will also motivate managers and directors to make decisions that increase shareholder wealth. Stock options give managers and directors the right to buy shares at a specific price at a specified time in the future. The specified price is typically at the current stock price, which makes the instrument not very different from a straight purchase of equity. The time element is key. The time element motivates managers and directors to make decisions for the benefit of shareholder wealth in the future, which is actually more important to long term holders of the stock.

The primary differences between giving shares and options are the above stated drawbacks. With options, management and directors do not get voting rights until the options are exercised. However, at the time of the option issuance there is no dilution of power or wealth to the existing shareholders. The second issue, volatility, is also avoided using options because management becomes more focused on long-term gains than short-term gains. Finally, options do not leave management and directors exposed to market risk. If the market declines for a period of time, the managers can choose to wait to exercise their options, significantly reducing diversifiable risk.

The primary drawbacks to using options are the increased complications of financial reporting and transparency. Options are hard to value and are not often included in financial statements at their full value. In the US, the regulators are trying to find ways to make the reporting of options more standard, but are finding it difficult to make a universal rule.

However, firms that are using options in the US have been embraced by investors, and most tend to report enough information for each investor to assess the total value instead of relying on the regulator’s valuation methods. Options have been especially beneficial to technology firms who can not afford to offer sufficient compensation packages to managers and directors from the beginning, but are able to give them the benefits as the firm reaps them.

"Sunlight is said to be the best of disinfectants: electric light the most efficient policeman." Justice L.D. Brandeis, Other People's Money 62 (1914)

In order to maintain a successful capital market, Taiwan must undertake steps to ensure the sufficient protection of investor interests. Disclosure rules that help create transparent transactions benefit both domestic and foreign investors from unwelcome surprises. The United States debated the merits of a mandatory disclosure system extensively until the unfortunate circumstance of the Great Depression and the market collapse in October 1929 provided the momentum and support for such a system. While many aspects of the functioning of capital markets are heavily influenced by cultural norms, disclosure rules are arguably a universal necessity. Deception and illicit activity in financial matters persists across cultures and disclosure rules help to fight it. In the United States, after the market collapse, one congressman commented,

A system that addresses the problem of uninformed investment in public offerings will help protect the investor, minimize risk and, in turn, boost the attractiveness of the capital market as a whole.

The necessity of mandatory disclosure rules versus natural manager incentives has been a central debate in securities law. The traditional view is that reporting requirements are a necessity because managers lack sufficient incentives to disclose reliable information in a timely manner (i.e., prior to their profiting from the inside information). Market efficiency theory argues that investors will discount the price of securities in the amount that the average manager is projected to appropriate profits. This discount will incentivize below-the-average managers to signal their trustworthiness in order to boost the stock value. Managers and shareholders can contract on a company level to incentivize. Market efficiency theorists believe that federal regulations burden rather than streamline this process. Other theorists argue that this effect will cause less honest managers to mimic the actions of average or more honest managers. In reaction, more honest managers will attempt to certify their status through independent audits and fuller disclosures.

However, another school of theorists believes that market efficiency and self-induced disclosure is not the most cost-effective approach to investor protection. Centrally mandated disclosure rules are cost effective if one believes that (1) information is a public good and, thus, is underprovided, (2) non-mandatory disclosure would be costly due to social costs incurred by investors pursuing trading gains, (3) self-induced disclosures (the second theory) assumes perfect manager-shareholder alignment of interests, a fallacy, and (4) even an efficient capital market does not induce the disclosure of certain information that is needed by investors to optimize a portfolio.

Academic debates aside, the general belief in practice today is that of disclosure as a means of regulating the honesty of managers, insiders and shareholders. As such, an understanding of what characteristics are key to an effective disclosure system can help a developing capital market make some regulatory decisions with regards to its own.

In the United States, securities market disclosure is regulated primarily under the aegis of (1) the federal Securities Act of 1933, (2) the federal Securities Exchange Act of 1934, and (3) state Blue Sky laws. The SEC administers the federal acts. The Securities Act of 1933 was developed to ensure fair disclosure in public offerings and control fraudulent practices in connection with the sale of securities. This is accomplished primarily through registration of key financials (under standardized accounting rules) and the required delivery of a prospectus to all potential investors. The Securities Act also provides investors with a right of action for materially false statements in the registration statement and a general prohibition against fraudulent and deceptive acts in the sale of securities.

The Securities Exchange Act sought to address a variety of problems that ensued including the insider profiteering and securities that escaped registration altogether. Thus the Exchange Act mandated regular filings of updated financial information and material acts, expanded the types of securities that must be registered and expanded the ability of the SEC to prosecute for the protection of investors.

State Blue-Sky laws are charged with assessing the actual merit of offerings. These laws reflected a prevalent view that hardworking common men and women were frequently victims of not just confidence men but also slick investment bankers from Wall Street. The laws originally were promulgated to curb promoters who would sell interests having no more substance than "so many feet of blue sky." Blue Sky laws also include provisions for the registration of broker-dealers, their agents and investment advisers, and antifraud prohibitions.

The Securities and Exchange Commission is an independent, nonpartisan agency created by the Securities Exchange Act of 1934. The Commission is composed of five commissioners appointed by the President to five-year terms, the terms are staggered so that one expires each June, and not more than three commissioners may be of the same party of the President. One of the commissioners is designated by the President to serve as the Chairman of the Commission. The commissioners meet frequently as a deliberative body to resolve issues raised by the staff. The Commission staff is divided into several divisions and offices. The Division of Corporate Finance has overall responsibility for administering federal securities laws' disclosure requirements by reviewing filed documents. The Division of Market Regulation oversees the operation of secondary trading markets. The Enforcement Division oversees investigations and prosecutions. The Office of the General Counsel represents the Commission in all appellate or other litigation brought by or against the Commission.

In the United States disclosure system several characteristics are essential to the success of it. First, is the principle of standardized disclosure. Companies must disclose comprehensive financial statements with explanations on a quarterly basis. These financial statements conform to a professional standard promulgated by a body of professionals (GAAP) that are held potentially liable for misstatements or omissions contained within them, thus controlling for a conflict of interest. The information required is standard for all companies, including accounting statements, management discussion and analysis, option valuation, and risk factors. Second, companies must disclose continuously. Companies disclose detailed financials on a quarterly basis and all material actions at all times. Continuous disclosure helps maintain a manager's honesty. Third, the administration of the law is by a nonpartisan body. In order to prevent conflicts of interests in the promulgation and execution of the laws, the governing body, the SEC is mandated to act as a neutral party. It is institutionalized by the rules requiring that the body not be ruled solely by one party. Fourth, even within the SEC, the staff is divided into functions for checks and balances. The rule-making body is separated from the adjudicating body, which is separated from the operational body. Fifth, the government supports the mission of the SEC and substantial funds are provided to staff the effort sufficiently.

Key corporate governance recommendations:

1. Keep boards small. Smaller boards have proven to be more effective in other countries because they tend to be more involved, there is less of a free-rider problem. On small boards, each board member is typically responsible for a committee and takes that responsibility seriously.
2. Include outsiders on the board, particularly consider including members of the university communities who are very well respected in the region. Including outsiders has also been shown as a best-practice around the world. Outsiders are recognized for not being able to be influenced by management. University faculty would be great additions to the boards in Taiwan, because of their understanding of the local markets and the history of it.
3. Improve communication and voting systems between the board and shareholders. Improving communication to the shareholders and their voting system will reassure the shareholders of their role as an owner of the company. A lack of this kind of input could cause shareholders to become activists instead of active participants.
4. Encourage ownership of the company by management and board members. Ownership of the company by management and board members is the easiest way to align the interests of the management and the board with those of the shareholders. See earlier discussion.

Adopting and promoting these key attributes of corporate governance that are widely used successfully around the world would help Taiwan in its quest to be one of the primary financial markets in Asia. Transparency and monitoring are key to investors and affiliated companies who do not have the available information and time to evaluate a company continuously.

Key disclosure recommendations:

1. Standardize disclosure. Standardized disclosure regulations and standardized processing of these regulations provide manifold benefits. First, standardized disclosure assures investors of the reliability of information. Thus, using the US example, all companies must disclose the same information and must adhere to uniform GAAP standards. Exceptions are granted on a macro level after careful nonpartisan review and approval. A body that is independent of companies (accountants) promulgates GAAP standards. Second, processing should be standardized, reducing the transaction costs for companies and, thus, encouraging compliance by companies. In Taiwan, additional documentation not specified in regulations is requested. Many times this documentation is extensive and involves full translations for foreign companies, making the application process costly and unattractive to foreign companies. Some information that is pertinent includes: financial statements, risk factors, management discussion and analysis of results, identification of senior executives, board and major shareholders, recordation of insider acquisitions and sales, control block acquisition and sales and proxy rules (notification of votes and elections to encourage shareholder participation).
2. Require continuous disclosure. Regular updates of information keeps investors informed of the status of the company and any material changes. Regular updates inform investors of problems while there is still time to rectify the situation. It allows investors to review the performance of management and reduces the ability of management to hide mistakes.
3. Administer disclosure and fraud regulations and law by a nonpartisan body. The current structure of the Taiwan regulatory bodies creates conflicts of interest. Prosecutors and administrators in the Taiwan SFC often are also those involved in the administration of the TSE and, thus, are unable to work independently in either capacity. The creation of a nonpartisan body is a core requirement of a successful and trustworthy capital market. The most common complaint of investors in developing economies is nepotism and cronyism. Neutral rules requiring that key administrators originate from various parties and from outside the "system" will help assure investors of the reliability of the regulations.
4. Create internal checks and balances to prevent corruption. As further assurance, the SFC structure should be such that there is a division of labor between promulgation and adjudication.
5. Devote considerable resources to the staffing of the effort. Extremely important, and only second to the requirement of an independent governing body, is the need for considerable resource to staff the enforcement effort. The mere existence of regulations is ineffective if they can not be properly enforced. This will discourage investors. In addition, a slow, bureaucratic process burdened by insufficient staffing will serve to frustrate companies hoping to register in Taiwan.

China’s economic development is similar to Taiwan’s in many ways. Similarities derive, in part, from the fact that before 1949, China and Taiwan were under the same leadership. As such, both countries experienced parallel economic conditions. Despite 50 years separation, the culture on the two sides of Taiwan Strait remains essentially the same. Learning from Taiwan’s successes could significantly shorten the development of China’s economy. (For a detailed timeline mapping China versus Taiwan’s development see Appendix B.)

1. Taiwan as a Blueprint for China

Taiwan’s achievement in economic development stemmed from several critical steps. The most critical steps included the government’s move to privatize property privatization, reduce government involvement, and promote industrialization and internationalization. Pivotal reforms included investing in infrastructure development, taking advantage of low cost labor forces, and building a regulatory and financial system with international standards. These reforms gave the economy the strength to sustain a high growth rate for more than three decades.

A more in-depth review of Taiwan’s development produces a 7-stage model. This model begins in 1945, with an agrarian focused economy. In the early fifties, Taiwan moved into its second stage, industrialization. Taiwan began industrializing almost a decade before China. This early move into industrialization is likely a strong driver of the current market formation. China’s severe imbalance in natural and human resource distribution hindered her ability to industrialize at the same rate as Taiwan. In China post-WWII, there was nearly no industrial infrastructure in place, the labor forces were poorly educated and trained, and 80% of the populations were farmers.

Throughout these first two stages property ownership reform remained central to both Taiwan and China’s reforms. In the early 50s, Taiwan government started land reform that transferred the ownership of land to sharecroppers and sold public land to tenants. This step provided the economy resources to move toward industrialization after the war. Similarly, China has recognized the criticality of property ownership, but again on a much later timeline. China’s privatization process includes ongoing SOE reform that returns ownership to private owners. Pushing this reform forward has given Chinese leaders tremendous challenges in balancing the employment rate, living standards, political and economic stability and the progress of the reform.

In the next several decades Taiwan established its capital markets. As early as 1961, the first stock exchange was established in Taiwan. China achieved a similar milepost thirty years later in 1991. Furthermore, an important difference between Taiwan and China’s development included Taiwan’s early establishment of securities regulation and regulators. In sharp contrast, China’s regulatory powers appear purposely less defined. As of 1998, despite China’s scale advantage, the market capitalization of both countries proves comparable.

As Taiwan’s markets benefited from privatization and increased competition, Taiwan entered a new stage, a focus on infrastructure development. Following Taiwan, China too, has turned to infrastructure development. However, China faces more binding constraints given its landmass and population. Constraints which the World Bank estimates will cost $70-$80 billion to address. China has achieved the development stages experienced by Taiwan to this point, but on a slower time frame. From this point forward Taiwan can serve as a model for China.

In order for China to move forward China must stabilize its banking system (Stage 5). Given the fragility of the current banking system, this is no easy or quick task. China suffers from an over-extension of credit, a bank-dominated financial system and weak central bank regulation. Taiwanese legislation offers some guidance for successful reform. The Banking Reform Law privatized commercial banks, removed controls on interest rates and clamped down on corruption. Taiwan expanded the number of bank licenses that had been restricted since the 70’s. Taiwan also allowed insurance companies to enter the market.

China cannot free up interest rates until principle banks are borrowers (namely SOE’s) are stable. If the market opens too quickly there could be a disastrous drain on cash. Although tenants of market reform characteristic of later stages of development have already been achieved in China – without the successful re-capitalization of the banking system, the potential for free-market economy remains uncertain.

In Stage 6, Taiwan’s strategy focused on economic liberalization. Reform for capital markets included allowing mutual fund companies to manage foreign-invested Taiwanese mutual funds and allowing qualified foreign institutional investors to invest in publicly listed stock (subject to quotas). Securities Investment Consulting Enterprises have emerged and mutual funds have been introduced. China has historically lacked the foreign aid Taiwan received from US.

As a logical consequence of privatization, Taiwan government took another strategic step in its economic development, reducing government’s involvement in business. Coupled with positive policies on exports, this step played a critical role in transferring Taiwan from central controlled market to a free market economy. Reforms in China that follow this path include efforts to relax controls over SOEs and the markets. Adopting a series of policies to provide managers and employees incentives and promote private business ownership are major tenants of this strategy. China’s exports have also been an increasing contributor to economic growth.

The final stage of Corporate Governance provides opportunities for both Taiwan and China to improve. Reform initiatives need to develop a stronger accordance with international accounting standards, greater credit management processes, and greater avenues for judicial recourse. China also needs to develop better taxation system to help with growing social burdens currently absorbed by businesses.

At the same time that China can use Taiwan as a model for successful development, China can also learn from Taiwan’s mistakes. For example, China witnessed the disastrous effect of having capital account convertibility and a heavily managed exchange rate during the Asian Financial Crisis.

2. Additional Recommendations

As China’s reforms move forward, the Chinese government has not only learned from Taiwan, but also from developed countries. Its regulatory and financial reforms have built international standards into the system. The central bank took the US Federal Reserve System as its prototype. The recent tax and fiscal reforms have also followed international practices.

Corporate ownership structure is one of the areas that China differs significantly from Taiwan. Up to now, a large percentage of Taiwan’s enterprises have a family as the major shareholder. This structure made, in most cases, the major shareholder the manager of the enterprise. Since China has a different wealth distribution pattern, this ownership structure is unlikely to take shape in China. The implication is that a robust financial market and a complete corporate governance mechanism are required. For China, the challenge is to develop a strong regulatory environment, an institutional foundation and an open financial market.

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