Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise
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Over the past 30 years China’s state sector has assumed the guise of Western corporations, listed companies on foreign stock exchanges and made use of such related professions as accountants, lawyers, and investment bankers. This camouflages its true nature: that of a patronage system centered on the Party’s nomenklatura. The huge state corporations have adopted the financial techniques of their international competitors and raised billions of dollars in capital, growing to an economic scale never seen before in all of Chinese history. But these companies are not autonomous corporations; they can hardly be said to be corporations at all. Their senior management and, indeed, the fate of the corporation itself, are completely dependent on their political patrons. China’s state-owned economy is a family business and the loyalties of these families are conflicted, stretched tight between the need to preserve political power and the urge to do business. To date, the former has always won out.
Of course the “National Champions” dispose of great wealth and, consequently, interest groups within the Party have formed around what one official once called “these cash machines.” But misjudgment forms the character of all human beings; a simple misstep can bring down a powerful wealth machine and the families behind it. The issue then becomes how to remove the political targets while preserving the machine. The “Party”—that is, the winning interest group—can intervene for any convenient reason, changing CEOs, investing in new projects or ordering mergers. Due to these characteristics, the adoption of laws, accounting standards, markets, and other mechanisms of international capitalism are just examples of the formalism that characterizes China today. The names are the same as in the West, but what things are and how they work is hidden beneath the surface. Given the state’s scale in critical sectors, together with the enormous power of the government, the influence of this patronage system pervades all aspects of China’s economy. It inevitably undermines the very contents of its superficially internationalized institutions.
The 30 years encompassed by the policy of reform and opening have been the most peaceful and economically successful in the past 170 years of China’s history, lifting more than 300 million people out of poverty. This achievement must be acknowledged. But the character of China’s style of capitalism is marked deeply by how the political elite has coalesced around certain institutions, corporations and economic sectors, how the government and various interest groups have used Western financial knowledge, and the crises the state has met along the way. After all, every country and all economic and political systems experience booms and busts, scandals and wild speculative sprees. The difference lies in how each country manages the aftermath. The aim of this book is to pull back the edge of the Chinese curtain and peer at what is behind, to match the reality of the system’s operations with the familiarity of the names it uses to describe them and then to look into the future in the belief that a straight forward look will benefit all.
ENDNOTES
1 See Xing 2007: 739.
2 This figure could be much higher since the market capitalizations of H-share companies listed on the HKSE value only the H-shares, excluding all other shares.
3 See Wu 2009.
4 For greater detail, see Walter and Howie 2006: Chapter 9.
5 The PBOC’s statement in June 2010 that the yuan is free to float against a basket of currencies remains just that, a statement, and is unlikely to lead to significant change in the currency’s value.
CHAPTER 2
China’s Fortress Banking System
“[W]e should not bring that American stuff and use it in China. Rather, we should develop around our own needs and build our own banking system.”
Chen Yuan, Chairman, China Development Bank
July 2009
In China, the banks are the financial system; nearly all financial risk is concentrated on their balance sheets. China’s heroic savers underwrite this risk; they are the only significant source of capital “inside the system” of the Party-controlled domestic economy. This is the weakest point in China’s economic and political arrangement, and the country’s leaders, in a general way, understand this. This is why over the past 30 years of economic experimentation, they have done everything possible to protect the banks from serious competition and from even the whiff of failure. In spite of the WTO, foreign banks consistently constitute less than two percent of total domestic financial assets: they are simply not important. Beyond the pressures of competition, the Party treats its banks as basic utilities that provide unlimited capital to the cherished state-owned enterprises. With all aspects of banking under the Party’s control, risk is thought to be manageable.
Even so, at the end of each of the last three decades, these banks have faced virtual, if not actual, bankruptcy, surviving only because they have had the full, unstinting and costly support of the Party. In the 1980s, the banking system had barely been re-established when uncontrolled lending at the insistence of local governments led to double-digit inflation and near civil war. The Asian Financial Crisis of 1997 drove internationally significant financial institutions such as Guangdong International Trust & Investment Corporation into actual bankruptcy. This compelled the government to undertake a bottom-up reorganization of the banks that it admitted publicly had 40 percent non-performing loan (NPL) levels. The origins of this restructuring can be traced to 1994, when the framework of a system that closely followed international arrangements was sketched out, including an independent central bank, commercial banks, and policy banks. The 1994 effort was stillborn, however, given the priority to bring raging inflation, which peaked at over 20 percent in 1995, under control. In short, China’s banking giants of 2010 were under-capitalized, poorly managed and, to all intents, bankrupt just 10 years ago.
A third decade has now gone by during which the banks completed their restructuring and subjected themselves to international governance and risk-management standards. By 2006, three of the four state banks had completed successful international IPOs. After the outbreak of the global financial crisis in 2008, China’s banks emerged as apparent world-beaters, besting their peer group in the developed economies in size of market capitalization and even topping the Fortune 500 list. They seemed to have weathered the global financial crisis well. But just, at this point, the Party, facing the seeming collapse of China’s export-driven economy, reverted to its traditional approach and ordered the banks to lend unstintingly to drive the economy forward. This green light may have erased whatever standards of governance and risk control that bank management had learned over the previous decade.
By the end of 2009, the banks had lent out over RMB9.56 trillion (US$1.4 trillion) and warning lights were flashing as capital-adequacy ratios approached minimum internationally mandated levels. In 2010, these banks are scrambling to arrange huge new capital injections totaling over US$70 billion (if Agricultural Bank of China’s IPO is included). Looking forward, the lending binge of 2009 threatens, and will most certainly generate problem loans of sufficient scale to require yet a third recapitalization in the next two to three years. China’s major state banks, the National Champions of the financial sector, appear to be heading toward a situation not unlike that of 1998. But their problems will, in fact, be much worse than 1998 since the old problem loans of the 1990s were only swept under the carpet. The “bad” banks, which took on those NPLs, were poorly structured, with the result that the “good” banks have remained liable. The government’s penchant for ad hoc funding arrangements, an unwillingness to open the problem-loan market to foreign participation, and the belief that it can perpetually put off the realization of losses pose a threat to the financial strength of China’s banks long before the NPLs of 2009 arise.
China’s banks look strong, but are fragile; in this, they are emblematic of the country itself. The Chinese are masters of the surface and excel at burying the telling detail in the passage of time. Their past experience tells them that this strategy works. But China, perhaps more than at any time in its long histo
ry, is now closely enmeshed with the larger world. The collapse of GITIC would never have taken place had it not been caught up in international financial arrangements. China’s financial system, similarly, has become increasingly complex; this complexity has begun to erode the effectiveness of the Party’s traditional problem-solving approach of simply shifting money from one pocket to another and letting time and fading memory do the rest. Tied up as it is in financial knots, the system’s size, scale and access to seemingly-limitless capital cannot forever solve the problems of the banks.
BANKS ARE CHINA’S FINANCIAL SYSTEM
In China, capital begins and ends with the Big 4 banks. The banking system has thousands of entities if the 12 second-tier banks, the urban and rural banks, Postal Savings Bank, and credit cooperatives, are included. But the heart of the system includes just four: Bank of China (BOC), China Construction Bank (CCB), Agricultural Bank of China (ABC) and, the biggest of them all, Industrial and Commercial Bank of China (ICBC). In 2009, state-controlled commercial banks held over US$11 trillion in financial assets, of which the Big 4 banks alone accounted for over 70 percent (see Table 2.1). These four banks controlled 43 percent of China’s total financial assets.
TABLE 2.1 Relative holdings of fi nancial assets in China, FY2009 (RMB trillion)
Source: PBOC Financial Stability Report 2010, various.
Note: *includes brokerages and fund-management companies.
Such a concentration of financial assets in the banking system is typical of most low-income economies (see Figure 2.1).1 What differs in China’s case, however, is that the central government has unshakable control of the sector. Foreign banks hold, at best, little more than two percent of total financial assets (and only 1.7 percent after the lending binge of 2009), as compared to nearly 37 percent in the international lower-income group. This will not change anytime soon. A very senior Chinese banker was asked in early 2010 about the government’s strategy for foreign banks and where the foreign sector would be in five years. He replied after some thought: “I don’t believe anyone has thought much about this; I expect that in five years’ time, foreign bank assets will constitute perhaps two or three percent of total bank assets.” Despite the undeniable economic opening of the past 30 years and the WTO Agreement notwithstanding, China’s financial sector remains overwhelmingly in Beijing’s hands. There appears to be little political acceptance of the need to diversify the holders of financial risk.
FIGURE 2.1 Concentration of banking assets by country income group
Source: Data from 150 countries; based on Demirguc-Kunt and Levine (2004): 28
If one looks at incremental capital raising, it is obvious the stock markets in Hong Kong, Shenzhen and Shanghai are an afterthought. It is bank lending and bond issuance that keep the engine of China’s state-owned economy revving at high speed. For example, 2007 was a record year for Chinese equity financing: more than US$123 billion was raised, but in the same year, banks extended new loans totaling US$530 billion and debt issues in the bond market accounted for another US$581 billion. In the past decade, equity as a percentage of total capital raised has been measured in the single digits as compared with loans and debt. Who underwrites and holds all that fixed-income debt? Banks hold over 70 percent of all bonds, including those issued by the MOF (see Chapter 4). Taking this a bit further, in the stock markets as well, the huge deposits placed by institutional investors seeking share allocations in the primary market are also funded by loans from banks. In China, the banks are everything. The Party knows it, and uses them as both its weapon and its shield.
CRISIS: THE STIMULUS TO BANK REFORM, 1988 AND 1998
Today’s banking system is the child of the financial crises that began China’s 30 years of reform and ended each of its next two decades. At the close of the Cultural Revolution in 1976, there were no banks or any other institutions left functioning. Beijing faced the challenge of institutional design and it was natural that it fell back on traditional Soviet-inspired arrangements. These can be described roughly as a Big Budget, the MOF, and small banks that did little more than lend short-term money. Nor was there an important role for a central bank. Most important of all, the key management of the banks was not centrally controlled by Beijing, but by provincial Party committees (the local Party always needs money). Over the course of the 1980s, this arrangement built up into a lending spree that ended in inflation, corruption and near civil war in 1989. In 1992, the Party, fired up by Deng Xiaoping’s words in Shenzhen, took the economy and its banking system straight back to where it had been in 1988. There were spectacular bubbles and busts, most notably the Great Hainan Real Estate Bust of 1993 (outlined later in this chapter).
In line with its decision in 1990 to try out capitalist-inspired stock markets, in 1994, Beijing abandoned the Soviet banking model in favor of one based largely on the experience of the United States. New banking laws and accounting regulations, an independent central bank, and the transformation of the four state banks into commercial banks all followed. Three policy banks were established to hold non-commercial loans. This effort, however, was stillborn, sidetracked by Zhu Rongji’s greater priority to bring the country’s raging inflation under control. It took the Asian Financial Crisis and the collapse of GITIC in 1998 to catalyze a sustained effort to transform the banks along the lines of the framework adopted in 1994.
China’s leaders, no matter who they were or are, know that the country’s financial institutions are the source of the greatest threat to financial and social stability. They differ significantly, however, over how to minimize this threat. The traditional impulse of the Party has always been toward crude outright control. For the banking system, this has meant an absence of control and the creation of new crises. Realizing this, Zhu Rongji and his team adopted a more sophisticated approach from 1998. Much as they did in reforming the SOEs, this team sought to create a more independent banking system by adopting international methods of corporate governance and risk management. Once this was in place, the key decision was to submit the whole to the scrutiny of international regulators, auditors, investors and law by listing the banks in Hong Kong rather than in Shanghai. The experience of China’s banks in the 1980s and 1990s shows why Zhu would seek such an approach and also sheds light on bank behavior in 2009.
The expansive 1980s
In 1977, China was bankrupt; its commercial and political institutions in tatters. There was no real national economy, only a collection of local fiefdoms held together by a broken Party organization. What strategy could be used to pull it all back together? Looking back to the 1949 revolution, China had sought to create a central planning system with the assistance of Soviet advisors in the 1950s. But, parsing those years between 1950 and the Anti-Rightist Campaign of 1957, only a start had been made. From 1957 to 1962, Mao Zedong threw China into its first prolonged period of disorder and invited all Russians advisors to go home. Pushed aside when the heavy costs of the Great Leap Forward were totaled up, Mao quickly made his comeback and, in 1966, threw the country into chaos for a further 10 years.
Under such chaotic circumstances, how much of a government, much less any planning system, really could have been put in place? Whatever the answer, there was no banking system when the Gang of Four was deposed in 1976; everything had to be rebuilt and the only model anyone knew of was based on blueprints the Soviet advisors had left behind. At the start of the reform era in 1978, there was only one bank, the PBOC, and it was a department buried inside the MOF. From this small group of only 80 staff, a great burst of institution building began.
New banks and non-bank financial entities proliferated wildly in the government’s enthusiasm for what it saw then as financial modernization (see Table 2.2). By 1988, there were 20 banking institutions, 745 trust and investment companies, 34 securities companies, 180 pawn shops and an unknowable number of finance companies spread haphazardly across the nation. Every level of government succeeded in establishing its own set of financial entities, jus
t as they have now set up “financing platforms” of every kind. It was as if money could be conjured up simply by hanging up a signboard with “financial” on it.
TABLE 2.2 The proliferation of financial institutions in the 1980s
Type and number of institution Date founded
1) 20 banking institutions including:
People’s Bank of China January 1978
Bank of China January 1978
People’s Construction Bank of China August 1978