Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise

by Carl E. Walter; Fraser J. T. Howie

  This entire effort is misdirected. It isn’t the absence of equity research that makes the market a casino. It is the absence of genuinely accountable companies subject to market and investor discipline. If the chairmen/CEOs of China’s major companies care little about the SASAC, they care still less about the Shanghai stock exchange or the legion of domestic equity analysts. The CEO knows full well that his company possesses the resources to assure the performance of its own shares. The National Champions dominate China’s stock markets, accounting for the lion’s share of market capitalization, value traded and funds raised.

  The growing number of private (non-state) companies listed on Shenzhen’s SME and ChiNext boards is encouraging, but most of these companies, with few exceptions, are tiny in the broader market context. Perhaps investors can look at the SME or ChiNext market and apply the usual investment analysis used in the international markets, but how can an investor look at PetroChina and compare it with ExxonMobil when it is nearly 85 percent controlled by the state and will remain so as long as the Party remains in power? It is the same with China Mobile or China Unicom; can they really be compared with Vodafone, T-Mobile, or BhartiAirtel? The fact that foreign telecommunication providers are barred from China’s domestic market means that China Mobile and China Unicom have a comfortable duopoly. Their privileged positions are simply not subject to the same regulatory or market checks and balances that their global peers face.

  The fact that the National Champions are all jumping at the chance to invest in China’s suddenly undercapitalized banks surely flags the question of whether National Champions can be looked upon as genuine companies or simple extensions of the government. How else to view China Mobile’s acquisition of a 20 percent “strategic” stake valued at US$5.8 billion in the Shanghai Pudong Development Bank, or China Unicom’s investment in the Bank of Communications, or Alibaba.com’s (China’s Google) investment in China Minsheng Bank?

  IMPLICATIONS

  Hovering over all this activity are the CSRC and the state in general. The state is involved at every stage of the market as the regulator, the policymaker, the investor, the parent company, the listed company, the broker, the bank and the banker. In short, the state acts as the staff for China’s major SOEs. With the National Team formed and with its senior management being coterminous with the very center of political power, can there be any true reform of corporate governance? Is it likely that they would accept the creation of a Super Regulator with real authority over the market and their own conduct? With the existing regulator already on their side, ensuring that the market is tuned in their favor, why would they want foreigners with their own ideas of how markets operate to have significant influence? So, no meaningful opening to foreign participation can be expected. In fact, the scope of foreign influence can be expected to be cut back even further as Chinese securities companies, law firms and auditors assert themselves and Chinese-style regulation is extended from Shanghai to Hong Kong.

  In late 2009, the first material step in this direction took place when the Hong Kong Stock Exchange indicated it would accept Chinese firms as auditors for Chinese companies listed on the Hong Kong exchange subject to their vetting by the MOF or the CSRC. Ostensibly, this was done to make Hong Kong more competitive with Shanghai, since Chinese auditors are far less costly than major international firms. Since the quality and reliability of disclosure is what this is all about, can international investors expect local firms charging one-third the price to produce meaningful financial reports of increasingly complex national companies? As for vetting by the MOF or the CSRC, one might expect a handful of firms to receive approval and that these firms would be quite attentive to the needs of the National Team and their staff. If foreign investment banks and others are now struggling to establish a presence in China’s domestic markets, it can only be because they know that their days in the lucrative Hong Kong market are numbered.

  Since China Life’s IPO on the New York Stock Exchange in 2003 was investigated for a possible Sarbanes-Oxley violation (there was none), no other members of the National Team have listed there. Instead, Hong Kong became the venue of choice. Now the overseas “returnees” are moving back to Shanghai where things, as one SOE chairman put it, are “a bit easier to manage”. This trend of events is quite ironic if it is considered in the context of why China opened its border to international share offerings. When Zhu Rongji gave the go-ahead for overseas listings in 1993, one of the key reasons was that the more professional and demanding standards of the Hong Kong regulators and international legal and accounting standards would upgrade the management capacity of China’s enterprises. Would Zhu now believe that after less than 20 years, his goals for China’s SOEs and their management have been achieved?

  ENDNOTES

  1 The NDRC’s predecessor was the State Planning Commission (SPC), which was founded in 1952. The SPC was renamed the State Development Planning Commission (SDPC) in 1998. After merging with the State Council Office for Restructuring the Economic System (SCORES) and part of the State Economic and Trade Commission (SETC) in 2003, the SDPC was restructured into the NDRC.

  2 See Kjeld Erik Brodsgaard, “Politics and business group formation in China—the Party in control?” unpublished manuscript, April 2010.

  3 If it can be found, see Caijing 176, January 8, 2007: 28–44. The issue was pulled from the market the day it was published.

  4 Ibid.: 42.

  5 See Walter and Howie 2006: Chapters 9 and 10.

  6 There are two major investor categories at present: 1) the “strategic investor” (zhanlue touzizhe ) who participates prior to the formal announcement of the transaction, gets a full allocation, but is subject to a one-year lock-up; and 2) those investors participating after the formal announcement, of which there are two types: a) the “offline” “regular legal person investor” (yiban faren touzizhe ), who is subject to a three-month lock-up; and b) the “online” investor, which includes retail and any other investor desiring to participate, who is not subject to any lock-up. In this last category, investors participate in the lottery and orders are subject to allocation.

  7 “Shenhua soars 87 percent but chief still not happy,” South China Morning Post, October 10, 2007.

  CHAPTER 8

  The Forbidden City

  A huge vermillion compound filled with immense golden-roofed palaces, moats, hidden gardens and carved dragons, the Forbidden City is the heart of China’s capital. It is a masterpiece that belongs to both China and the world, for surely by now half the world must have walked through its spaces. Perhaps the significance of its structural layout exceeds even the riches left by the Yuan, Ming and Qing Dynasties and goes to the heart of Chinese organizational culture.

  Entering the palace through the Meridian Gate, one is struck with the great spaces enveloped by looming outer walls. Once through these massive walls, the visitor walks across marble bridges spanning the Golden Waters toward the Gate of Supreme Harmony. This is another, even broader, space, overwhelming in its grandeur, its walls receding into the distance. The courtyard’s overall design is awe-inspiring; it seems to encompass both heaven and earth. As one penetrates more deeply into the palace, however, spaces become smaller, and long, narrow corridors are punctuated here and there by small entrances. The huge walls close in, progressively blocking off all lines of sight.

  Even before finally entering the Imperial Garden, with its constricted space, rock gardens and towering Hall of Imperial Peace, the visitor comes to the realization that, like the gardens and the trees, he too is boxed in by the design. The great spaces at the Palace entrance are mere illusions because, in truth, there is just one way to look beyond the walls and that is to look up. Only the Emperor in his palaces atop the walls could see into the courtyards both large and small; those below were constrained to act within their allotted space. Cut off by walls from other courtyards and, indeed, the rest of the Palace, within their own space people were free to pursue the activities assigned to the
m. Only the Emperor had the authority to intervene and only he could understand the larger design of their work.

  The workings of the Forbidden City in Imperial times serve as a metaphor for China’s government and political practice today. At the center lies Beijing, a complex labyrinth of separate power centers, each with just a single reporting line that extends up to the party secretary general (although nominally through the State Council, the premier and the National People’s Congress). Coordination or integrated action across multiple bureaucracies is difficult and time-consuming unless it is ordered by the party secretary general. Without a strong leader, each bureaucracy proceeds within its own scope of authority and jealously guards the entrance to its courtyard. The only way to join the “emperor” in his palaces a top the walls is either through lineage, or by maximizing achievements within one’s own narrow grounds, or both. Then, of course, there may be some who prefer to stay within their own courtyards, pursuing their own interests.

  As the China Development Bank’s attempt to replace the Ministry of Finance in the bond markets and the tug-of-war between the MOF and the People’s Bank of China over control of the major banks have shown, there is a great deal of predatory behavior exhibited within the walls of this monumental edifice. There is also much copycat behavior. The China Securities Regulatory Commission (CSRC) has its securities companies and stock markets in one courtyard; in another, the China Banking Regulatory Commission (CBRC) has its own investment-banking platform, the trust companies, and access to the debt markets. And how else to explain the SASAC’s belated press release that it has created its own domestic sovereign-wealth fund in replication of China Investment Corporation; or to explain Huijin, which itself replicates SAFE Investments? It would be easy, of course, to go beyond these relatively specialized entities to include the large SOEs. When PetroChina acquires companies overseas on behalf of the government, isn’t it also a sovereign-wealth fund? All this demands the simple question: What in China isn’t a sovereign-wealth fund?

  Only a strong premier or party secretary can coordinate such activity to ensure it is in line with the Party’s general goals; only they can channel the energies of government and Party leaders and minimize costs. The absence of a strong leader is a weakness that allows the special-interest groups to take advantage. A vice-premier in charge of finance may understand his remit, but unless he has the ear of the general secretary, it is to no avail. A central bank governor may know clearly the critical issues across the financial maze, but unless he is supported, political compromise will trump all else. On the other hand, for the National Team, the less scrutiny there is, the better.

  THE EMPEROR OF FINANCE

  This perspective suggests just how great an achievement the securities markets, no matter how flawed, really are. From 1992, for the first time in its long history, China had a national market and it was a market for capital, and that capital could flow without hindrance across all government jurisdictions. Not only that, at the start these markets had a single “emperor” overseeing them, the People’s Bank of China. The PBOC (or, more accurately, its powerful provincial branches, together with the local Party) was the great force behind market development during the late 1980s. Liu Hongru, a PBOC vice-governor at the time, is commonly recognized by all participants as the “godfather” of the stock markets. The central bank oversaw the establishment of China’s first 34 securities companies in 1988. From 1985, its Shenzhen branch played a critical role in developing market infrastructure and regulations, while the PBOC head office played the key coordination role among government-market stakeholders. Without the PBOC’s initiative and support, China’s experiment with shares and stock markets would have been stillborn. Moreover, the PBOC’s sponsorship opened the international markets to Chinese IPOs, as was resoundingly demonstrated in October 1992 with the first-ever listing of a Chinese SOE on the New York Stock Exchange. This sort of daring would never have been possible with consensus leadership.

  Over the course of the 1990s a fragmented regulatory environment began to take shape, particularly after 1997 when Zhu Rongji moved the government-bond market from the securities exchanges and the CSRC’s oversight to the inter-bank market under the supervision of the PBOC. This was just the beginning. By 2003, seven regulators were responsible for the four major categories of bond products, and equity and commodities had also been parceled out. Each regulator had its favored group of financial institutions or markets—the PBOC had the debt markets; the CSRC and the NDRC had the securities companies and commodities brokers; the MOF had the banks; the CBRC had the trust companies; and the CIRC had insurance companies and private-equity funds. Now even the NDRC is looking for that special vehicle that can give it access to the financial markets. The capital markets are thus divided up into small areas of special interest and members of that group are thereby guaranteed a slice of the action with the help of their own patrons (see Figure 8.1).

  FIGURE 8.1 Capital-market products by regulator and business beneficiary, FY2009

  Source: Wind Information

  This is not to say that a single Super Regulator is necessarily the answer to coordination across China’s capital markets. There are good reasons for different regulators for different sectors; stock broking is not banking, and vice versa. The trouble is that in China, the different regulators have over the past few years created so-called “independent kingdoms”; effective coordination across these fiefdoms has been difficult in the apparent absence of strong political leadership.

  The lack of a unitary market regulator may have been less important in the 1990s when banks were almost the sole source of capital in the economy. But after the Asian Financial Crisis, Zhu Rongji’s plans to radically restructure the Big 4 banks required a far more integrated approach. Recapitalizing the banks was only one part of a larger plan designed to address the problem of systemic risk. But an integrated solution required the coordination and active support of a wide variety of government agencies including the MOF, the SPC/NDRC, the CSRC and the PBOC. Who would lead? Zhu Rongji was both willing and able to drive financial reform forward until the end of his term in 2003; the momentum that had built up from 1998 carried through until 2005. But, in his absence, when the PBOC sought to institutionalize these reforms in 2005, with itself as the Super Financial Regulator, supporters of the status quo, led by the MOF, pushed back hard enough to stop the consolidation of an integrated approach to financial markets.

  As outlined in earlier chapters, when the MOF took back control of the banks from the PBOC, China’s financial system incurred a high cost for its bureaucratic revenge. Foreign investors made a down payment through their participation in IPOs that were, in fact, a prepayment of cash dividends used to make good the interest payments on the MOF’s Special Bond. For their part, China’s major banks became simple channels for this interest, as well as for payments on the special “receivables” the MOF used to restructure Industrial and Commercial Bank of China and Agricultural Bank of China. It would seem that with the MOF’s interest being paid by the banks, the national budget did not need to bear the expense. Perhaps this explains why this Special Bond is no longer recorded in the PBOC’s central depository; after December 31, 2007, these bonds simply disappeared. In addition, the major banks are now in search of another US$42 billion to fill an equivalent gap in their capital created by dividend payments. Even more ungainly, the new sovereign-wealth fund suddenly found itself to be the heart of the entire banking system.

  These are the costs to the system when complexity reigns and there is no “Emperor of Finance”. Since 2005, there has been some talk of a unitary financial regulatory body, but there has been little of any substance to emerge except, perhaps, the idea of a “Super Coordinating Commission” that would include all stakeholders. However, just such an agency had existed before, in the late 1980s, and had proved a failure. Who would lead such a commission when even previous coordinating meetings between these regulatory agencies had lapsed into disuse becaus
e of “scheduling difficulties”?

  BEHIND THE VERMILLION WALLS

  So, without a strong champion for change, the status quo asserted itself; each of the major stakeholders in the system settled back inside its own “courtyard” and pursued their own interests including, especially, seeking access to increasing amounts of bank money. This poorly coordinated chase for funding has rapidly led to significant growth in China’s public-debt burden. The data in Table 8.1 illustrate the various stakeholders who have contributed to China’s stock of public obligations. For simplicity, the only changes in the projection for 2011 from 2009 are in the estimates of local-government obligations and non-performing loans, the two areas with potentially the greatest variability. These estimates are meant to be conservative and serve simply to show the scale of debt that has already been built up. To be clear, these numbers represent debt obligations; this does not imply that there is no value to the assets or services or other activities that such debt finances. But at a certain point, the cost of these liabilities adds up to a critical mass, becomes burdensome for an economy, and begins to inhibit economic growth. The international standard for such a red line is 60 percent of GDP, beyond which growth may suffer as a government spends more on managing its debt burden than on investing in growth-creating programs.