Tiger Woman on Wall Stree

by Junheng Li

  As the global economy remained sluggish, the legacy problems from China’s overinvestment in 2009 began to rear their heads, including the often-talked-about imbalance between domestic consumption and investment. Much of China’s economic growth had been sustained by fixed-asset investments led by the government, resulting in an increasing role of the government at the expense of consumers and the private sector.

  In China, domestic consumption lingered around 35 to 40 percent of GDP—dozens of percentage points lower than that of any other major economy, including the United States at 70 percent and Japan at 60 percent.

  Some economists claim that capital expenditure figures for China overstate the real amount of investment in the economy, because China’s investment figures likely include a high percentage of unrecorded “corruption rent”—income and wealth extracted from corrupt practices—which eventually is used to buy high-end luxury products or spent in Macao casinos. However, there can be little doubt that the Chinese system excels at pumping money into investment projects and that industries such as steel mills, chemicals, and high-speed railroads are experiencing selective but growing overcapacity.

  Crowding Out the Private Sector

  Economists widely recognize the danger of the structural imbalance between investment and domestic consumption in China. However, the inequity between the large SOEs and the small and medium-sized enterprises (SMEs)—the SMEs being the bedrock of China’s real economy and engine of organic growth, innovation, and employment—represents a worse problem whose significance is often underappreciated.

  In terms of long-run growth, the way credit is allocated in the economy is just as important as the total amount of credit. China’s economic growth has been predominantly driven by low-margin and high-volume production, a system that favors SOEs in the manufacturing and industrial sectors that can obtain economies of scale. The service sector and private businesses in general have been starved of credit—one of the reasons that many private Chinese companies come to U.S. capital markets to raise funds. A further obstacle to start-ups and their subsequent growth is the fact that individuals and SMEs cannot collateralize land effectively, since the government technically owns all land in China.

  As economies grow richer, structurally more complex, and more diversified, central planning and personal connections become less effective means of allocating resources, from natural and human resources to credit. The rule of law, markets, and arm’s-length regulation are far more effective and efficient in this regard. It is clear that China has reached a point in its development where it should move toward a rules-bound market economy and away from the top-down micromanagement that served the country well for the previous 30-plus years.

  Proponents of state capitalism argue that SOEs played a strategic role in driving the economy during its early catch-up growth phase, in which China’s central planners took advantage of a surfeit of cheap labor and heavy capital investment to create the world’s biggest manufacturing-driven export-oriented success story. This model eventually hit the wall, however, as overall inflation (including wage, rents, material and other resources) squeezed the profit margin—in many cases to negative earnings—for many industrial sectors.

  As this model became obsolete, SMEs began to prove vital in transforming China into an innovative economy driven by domestic consumption and capable of making optimal use of scarce and skilled labor. SMEs—mostly small businesses that have sprung up since the start of market-oriented reforms in the 1980s—contribute more than 65 percent of China’s GDP and are responsible for 75 percent of employment.

  Innovations are rare among SOEs simply because innovation requires risk taking and a corporate culture that rewards it, something that is not encouraged in the central planning culture of SOEs. Executives who come to their bosses with innovative ideas can expect a small upside in the case of success, maybe a marginal pay raise, but a much larger downside in the case of failure—perhaps losing their job. Taking orders, not risks, is the unwritten rule of thumb for SOE employees.

  Despite all the benefits they delivered to the Chinese economy, SMEs have not been given the government support they deserve. For one, SMEs are significantly handicapped in competing for cheap capital. This is partly because the government favors SOEs, but it is also because bank lending in China is collateral based. SOEs tend to operate in established and asset-heavy industries such as telecom, infrastructure construction, and steel, giving them plenty of fixed assets to put down as collateral. Because of their ties to local governments, SOEs also have much better access to land titles (rights to use the land), the collateral of choice for as long as banks have existed. Meanwhile, a high percentage of SMEs compete in service industries, with little or no fixed assets. SMEs also often have a short track record of operation and little or no credit history, a universal source of funding problems.

  SOEs are far more likely to be able to obtain adequate capital on affordable terms, permitting them to expand their businesses. SMEs, cut off from bank loans, have to turn to the gray market to find capital. In Wenzhou, the capital of Chinese capitalism, SMEs borrow at interest rates as high as 85 percent, while SOEs often take out loans at single-digit interest rates. As the flood of bankruptcies in eastern China in 2011 demonstrated, borrowing at such high interest rates is an extremely risky practice for small businesses.

  Shadow Banking

  Until the summer of 2011, China’s economic juggernaut seemed unstoppable. But starting in the fall, an acute credit crunch hit Wenzhou. A coastal city of 9 million about 300 miles south of Shanghai, Wenzhou had been a prosperous treaty port for centuries. It had earned a reputation as a hub of private wealth and enterprise, with a business-minded population known for its self-reliant and independent streak.

  The city specialized in low value-added manufacturing, producing 70 percent of the world’s cigarette lighters and 60 percent of its buttons, among other products. But since 99 percent of Wenzhou businesses were private, entrepreneurs didn’t have access to affordable bank loans to fund their businesses. Therefore they had to borrow from underground banks and pawnshops, and the city soon became a nexus of shadow banking—and eventually an illustration for its risks.

  Shadow banking typically refers to a system of credit intermediation between savers and borrowers involving entities and activities outside banks. In the United States, the main shadow banking players are hedge funds, venture capital, and private equity funds. Payday loan providers and money market funds are also considered part of the shadow banking system. Like banks, they borrow short and lend long, or else they fund themselves using short-term, liquid instruments while investing in long-term, often illiquid assets. Both banks and shadow banks experience mismatches in terms of liquidity, credit risk, and the duration or maturity of their assets and liabilities. Unlike banks, however, shadow banks often escape the close scrutiny of regulators and supervisors, even though many of them are owned or controlled by banks or bank holding companies.

  In China, the world of shadow banking includes many smaller and less-regulated entities, including trust companies, pawnshops, guarantors, small lenders, underground banks, and wealth management products marketed at banks. Since these activities take place outside China’s regulatory framework, figures on the scope of shadow banking are imprecise. But some economists estimate that total public and private debt, including shadow bank loans, could be as high as 200 percent of GDP.

  In Wenzhou, private business owners took out loans from shadow banks to invest in their projects, sometimes expanding into unrelated and highly speculative projects such as real estate development. A credit bubble slowly grew in the city. With little or no regulation of underground lending and other forms of shadow banking and no required disclosures, shadow bankers were less able to assess risk and ultimately lent to riskier businesses. The shadow banking system was vulnerable to several potential stress points, including the deterioration of the real estate market, the weakening of exports or manufacturing retu
rns, or even the investments of individual entrepreneurs going bad.

  It wasn’t just one of these factors that was Wenzhou’s undoing—it was all three together. These financial arrangements worked fine when there was optimism, confidence, and trust between parties. But those sentiments didn’t survive the financial crisis. As the global recession deepened and demand for exports plunged, the whole town began to default. Optimism, confidence, and trust turned into pessimism, fear, and distrust, and the complicated layering of credit and debt created during Wenzhou’s good times imploded much faster than it had grown. Loan sharks disappeared in the middle of the night, construction ground to a halt on half-completed apartment blocks, and property prices plunged. More than 80 prominent local businesspeople committed suicide or declared bankruptcy as they found themselves unable to pay back their gray market loans. China’s high-speed economy appeared to be running off the tracks, with Wenzhou leading the way.

  The situation continued to worsen in 2012. In a note uncharacteristic of the typically bullish nature of most sell-side analyst reports, one bank analyst issued a report that summer describing in detail the desolate streets and empty department stores of a now-bankrupt Wenzhou. The analyst noted that factories had shuttered their doors for a month or more after seeing orders decline by one-third, year on year, and that owners said this was the hardest time they’d seen in 18 years. Prices at a luxury riverside residence dropped to 50,000 RMB per square meter from more than 70,000 RMB in one year. “Fiddling with iPhones, reading newspapers, playing cards and sewing have become the favorite pastimes. . . . It isn’t what I expected at all,” the analyst wrote. “I was hoping to be overwhelmed by skyscrapers like Shanghai’s or roads like Beijing’s. But Wenzhou is disorganized. Debris and waste dot the city.”

  This account showed the deplorable consequences of the triumph of China’s unique form of state capitalism, characterized by the distorted allocation of capital and human resources and the consequent uneven playing field. SOEs were still surviving and even thriving because of their monopolistic positions and government support. But private enterprise, the source of most of China’s GDP and jobs, was struggling, with slim access to financial and human capital.

  One facet of shadow banking—wealth management products, or WMPs—has deeply penetrated the ranks of retail investors around the country. Many Chinese, including friends and families I know in China, purchased these financial products at one time or another, since they offer a significantly higher yield than saving accounts do.

  WMPs are bank-generated investment products that are sold to the banks’ retail and institutional customers. Similar to money market funds, WMPs pool funds with a relatively short investment horizon (as little as five days) and invest them in longer-duration assets to arbitrage the difference in returns. Disclosure on these products, including the assets they invest in and the likely returns of each, is limited. WMPs essentially circumvent China’s tight control of interest rates by rewarding investors with higher returns than deposit rates.

  Everbright Bank first pioneered this form of shadow banking in September 2004 as a way to attract retail deposits—the bank would require a customer to open a savings account before buying WMPs. Other banks followed suit, and competition among WMPs heated up. WMP issuance surged in 2010 as inflation accelerated; real interest rates dipped into the negative, and depositors who realized they were actually paying for the privilege of depositing their money in the bank moved money out of their savings accounts in droves. As China further tightened monetary policy in 2011, banks scrambled to attract deposits to meet their required loan-to-deposit ratios, and WMP growth accelerated further. Ratings agency Fitch estimated that China had around 13 trillion RMB of WMPs outstanding by the end of 2012, an increase of over 50 percent on the year.

  In principle, with authorities capping deposit rates at below-market levels, the emergence of financial products that circumvented the cap and offered a higher rate of return did not necessarily compromise stability. In other words, the excess return on a WMP over the officially controlled deposit rate did not necessarily imply that the WMP was riskier than a bank deposit. Instead, the higher return could be a reasonable approximation of what the real deposit rate would have been without an artificial ceiling.

  However, WMPs rapidly moved beyond that point, offering returns well in excess of an appropriate level for a depositlike investment. The trust funds and other providers of WMPs invested in high-risk projects in order to offer spectacular returns. Most investors in WMPs—typically, average middle-class households—didn’t realize that these returns included a significant risk premium. Like so many before them, in different times and places, these investors considered “excess returns” to be evidence of their acumen as investors—what financial pundits call alpha—rather than compensation for increased risk that would likely materialize at some point—what financial pundits call beta.

  Central to the WMP structure is the pooling of investor funds. The general pool will fund a variety of assets across the risk spectrum, many in the shadow banking sector. The average Chinese people who buy WMPs basically have no idea what they are buying. Xiao Gang, the chairman of the Bank of China, wrote a controversial op-ed in the state-run China Daily newspaper in October 2012, in which he called WMPs a Ponzi scheme. But most investors overlooked these warnings until several WMPs started to default.

  One WMP in particular became infamous. The Chinese investment vehicle known as Zhongding promised investors a short-term return as high as 11 to 17 percent, many times what Chinese investors typically earn on bank products. Even though the investment threshold was at least 500,000 RMB, customers still flocked to the product. Huaxia Bank, which marketed the Zhongding product, provided exceptional service for the VIP clients the product targeted. Those interested in the product would be ushered into a VIP room for a pleasant conversation with the lobby manager and only had to sign on the dotted line.

  Banks sold all kinds of WMPs, but they guaranteed roughly only half of them. Many WMP investors realized this fact for the first time on November 25, 2012, when Ms. Wu, one of those well-served Zhongding investors, was told that she wouldn’t get her money back. The managing partner of the product, Tongshang Guoyin Asset Management Company, told the banks that had marketed the product that the company could pay customers neither the interest nor the principal. Crowds of angry investors who had bought Zhongding and other WMPs formed outside the Huaxia branches in Shanghai. State media quickly painted the default as a one-off event: according to the press, the fault lay with Chengyang Wei, who ran the Zhongding Wealth Investment Center and who had spent seven years in prison due to financial fraud in the past. Huaxia Bank’s management was outraged and put the blame on “a rogue salesperson” for selling those problematic products without permission from headquarters.

  Other defaults soon followed the Huaxia incident, calling into question the safety of other WMPs. That same month, customers at a branch of China Construction Bank in the northeastern province of Jilin suffered a loss of 30 percent of their principal claim from a WMP. Soon after, Citic Trust Co, a unit of China’s biggest state-owned investment company, missed a biannual payment to investors in one of its trust products after a steel company failed to make its interest payments on the underlying loan.

  I began to investigate the WMP offerings from various banks as investor anxiety over WMPs grew. My company started to monitor the websites of banks and third-party marketers to track new issuances, including the volume, rates, and maturity dates. We also registered with major banks as WMP clients so we would get the updates on their promotions. We regularly called their hotlines, and we monitored online discussions on WMPs from all major social networking and news sites. Based on this, I believe that default risk is significantly underpriced for most WMPs. Retail investors who view them as a safe deposit with higher rate of return stand a good chance of losing their money. For Chinese retail investors, the lesson should be clear: if something looks too good to be
true, it almost surely is. The lessons for foreign investors should be clear as well: U.S.-listed Chinese banks are simply not suitable investments. The stocks may look cheap compared with the companies’ book values, but the book value could be miscalculated. I often call China’s economy a black box, but the banking sector is the darkest part of all. Chinese banks need to be cleaned up, be recapitalized, and become much more transparent before they can be investible.

  In fact, the leading American banks recently sold stakes in Chinese banks. Bank of America sold part of its stake in China Construction Bank, while Goldman Sachs sold a $2.3 billion stake in Commercial Bank of China last year, following a similar sale of its holdings in ICBC. The American banks claimed they were just raising cash, but I believe opacity and corporate governance issues played a major part in their decisions.

  By 2013, anxiety over a bubble in China’s economy was beginning to grow in the United States. The TV show 60 Minutes aired an exposé on the Chinese real estate bubble, and known China bears like hedge fund manager Jim Chanos and economist Michael Pettis gained airtime. The world was tuned in to see whether China’s economic miracle would crash and burn.

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  The shortcomings of China’s financial system pose potential near-term risks that could trigger a deep recession with profound global implications—what traders like to term a high-frequency risk. I believe that the real source of China’s long-term vulnerability, or low-frequency risk, lies in the country’s education system, which undermines the integrity and creativity of young minds and ultimately the nation’s labor productivity. Many people in the West believe that China is rising because Chinese kids are more competitive than kids in America. But I view the education system as China’s Achilles’ heel.

  When foreigners visit China, they are often impressed by the country’s spectacular hardware: the modern architecture of the coastal areas, the fancy international hotels and luxury shopping malls, a high-speed railway that is faster and more comfortable than Amtrak in the United States, the brand-new subways with Wi-Fi access. The continuous news cycle on America’s economic stagnation and Europe’s structural decline reinforces this shortsighted view. Visitors to China leave after their short stay, thinking that China is going to take over the world.