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IMPORTANT DISCLAIMER:

THE FOLLOWING PRESENTATION REPRESENTS MY PERSONAL OPINIONS AND DOES NOT REPRESENT A COMPRHENSIVE ANALYSIS OF THE CHINESE ECONOMY. ALTHOUGH THE INFORMATION CONTAINED HAS BEEN OBTAINED FROM SOURCES BELIEVED TO BE ACCURATE I CANNOT GUARANTEE ITS ACCURACY, COMPLETENESS, OR FAIRNESS. OPINIONS INVOLVE NUMEROUS ASSUMPTIONS WHICH MAY OR MAY NOT PROVE VALID AND WHICH MAY BE CHANGED WITHOUT NOTICE.

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Macroeconomic Review

Growth Drivers Monetary Policy & the Currency Social Implications

Banking & Finance

Corporate Finance

Regulatory & Market Structure

Party & State

Overview of Political System

A Brief History of Reform

Industry & the State Structural Vulnerabilities Summary & Conclusion

• Macroeconomic Review Growth Drivers – Monetary Policy & the Currency – Social Implications – •

Ren Xiong (1823­1857) 任熊 Late Qing dynasty painter of the Shanghai school

• Macroeconomic Review Growth Drivers – Monetary Policy & the Currency – Social Implications – •
I. Macroeconomic Review
I. Macroeconomic Review

Since reform began in 1978, China has achieved spectacular growth:

9.8% annual growth since 1978

 

World’s 2 nd largest economy in 2010

World’s 18 th largest economy in 1978

 

IMF predicts:

 

China GDP USA GDP by 2016 PPP

Notable divergence from developed world in 2008‐2009

Consensus view –

‘Gradualist’ school

China is incrementally converging with Western economic and political norms

China will overtake the US as global consumer and economic leader

• Since reform began in 1978, China has achieved spectacular growth: – 9.8% annual growth since
• Since reform began in 1978, China has achieved spectacular growth: – 9.8% annual growth since

China’s growth record is impressive, even when compared to other emerging markets:

GDP

16000 14000 12000 China 10000 US Euro Area Canada 8000 Japan India Brazil 6000 Korea Indonesia
16000
14000
12000
China
10000
US
Euro Area
Canada
8000
Japan
India
Brazil
6000
Korea
Indonesia
Malaysia
4000
2000
0
1980
1985
1990
1995
2000
2005

In billions of USD

Source: IMF

How has this been achieved so quickly?

China’s Share of World GDP – 1978­2010

9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 1980 1983 1986 1989 1992 1995
9.0%
8.0%
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007

Source: IMF

How has China gone from being an economic backwater to threatening American supremacy in just 30 years?

Maintain weak renminbi RMB to preserve export competitiveness Restrain inflation Achieve consistent growth 7‐8% explicit
Maintain weak renminbi RMB to preserve export competitiveness Restrain inflation Achieve consistent growth 7‐8% explicit

Maintain weak renminbi RMB to preserve export competitiveness

Restrain inflation

Achieve consistent growth 7‐8% explicit target

Maintain weak renminbi RMB to preserve export competitiveness Restrain inflation Achieve consistent growth 7‐8% explicit

How does China manage this seemingly impossible balance?

We address each of these points in turn before reviewing China’s financial and political economy:

Chinese macro‐economic policy attempts to balance:

Open capital account

Necessitated by reliance on trade Porous capital controls Open to foreign direct investment (FDI) with limited portfolio flows

Fixed exchange rate Managed peg to USD

Independent monetary policy

Theory suggests this is impossible 1,2,3

The ‘Impossible Trinity’

This balance has been achieved by the state’s coercive power and its dominance of domestic markets

Chinese macro‐economic policy attempts to balance: • Open capital account • Necessitated by reliance on trade
Chinese macro‐economic policy attempts to balance: • Open capital account • Necessitated by reliance on trade
  • 1 – R.A. Mundell, “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates,” Canadian Journal of Economics & Political Science 29 (1963)

  • 2 – M.J. Fleming, “Domestic Financial Policies under Fixed and Floating Exchange Rates,” International Monetary Fund Staff Papers 9 (1962)

Having Your Cake…

Exports subsidized by central bank, the People’s Bank of China (PBOC) Monetary authority, acts in broadly similar fashion to developed market central banks

Normally, China’s persistent trade surplus would cause the renminbi (RMB) to strengthen against the dollar (USD):

The PBOC prevents the trade balance from adjusting by intervening in FX markets to maintain the weak RMB

Prints RMB to buy dollars in open market operations

Transacted as much as $1.8 bn/day in 2007! 1

A Brief History of Chinese Currency Manipulation ‘97‐’05 ‐ China formally pegged RMB against USD ’05–’08
A Brief History of
Chinese Currency
Manipulation
‘97‐’05 ‐ China formally pegged
RMB against USD
’05–’08 – Managed float allows
for ~20% appreciation
’08 ‐ Present – De‐facto USD peg
@ ~6.80 RMB/USD – global
slowdown calls for halt to
appreciation

Inherently inflationary; impact must be compensated for Impact ‘sterilized’ by removing currency from circulation

Sterilization causes significant local and international economic distortions Sterilization can only postpone inevitable adjustments

1 – J. Greenwood. “The Costs and Implications of PBOC Sterilization,” Cato Journal Vol. 28, No. 2 (2008)

Having Your Cake… • Exports subsidized by central bank, the People’s Bank of China (PBOC) •

… and Eating It Too

The mechanics of sterilization:

Chinese exporters receive USD from American buyers Exporters sell USD to PBOC Exporter receives newly created RMB from Printing RMB offsets natural adjustment

PBOC accumulates USD reserves, RMB supply

Newly‐printed RMB must be ‘sterilized’:

USD used to purchase foreign assets:

Largely parked in US Treasuries No sufficiently large/liquid alternatives Reserves deployed increasingly aggressively via sovereign wealth funds etc.

Asset purchases augmented by financial repression:

Necessary to minimize leveraged effect of RMB creation through fractional reserve banking

A Brief History of Chinese Currency Manipulation

… and Eating It Too • The mechanics of sterilization: • Chinese exporters receive USD from

Free from the rule of law, China has used financial repression to limit the inflationary impact of perpetual money printing:

PBOC sets deposit and lending rates artificially

PBOC imposes lending quotas on banks

Free from the rule of law, China has used financial repression to limit the inflationary impact

PBOC issues ST notes and ‘Special’ Bills to banks

Low yielding bonds forced upon banks to immobilize bank assets – below market coupons De facto increase of bank reserve requirements 5.1% of domestic assets at 12/31/10 1

Bank reserve requirements

23.5% of domestic assets at 12/31/10 2

~30% of bank capital immobilized Inflationary pressures continue nonetheless…

Free from the rule of law, China has used financial repression to limit the inflationary impact

1, 2 PBOC 2010 Annual Report, China Banking Regulatory Commission

“China has made capping price rises the priority of macro ­ economic regulation and introduced a

“China has made capping price rises the priority of macro­economic regulation and introduced a host of targeted policies. These have worked. We are confident price rises will be firmly under control this year.”

‐ Wen Jiabao (温家宝), 6/23/11 Financial Times editorial

20% 15% 10% SHIBOR 3 Mo. Deposit Rate 3 Mo. 5% CPI, YoY PPI, YoY 0%
20%
15%
10%
SHIBOR 3
Mo.
Deposit
Rate 3 Mo.
5%
CPI, YoY
PPI, YoY
0%
1/1/2007
1/1/2008
1/1/2009
1/1/2010
1/1/2011
-5%
-10%
-15%

Source: PBOC, Bloomberg, China Economic Information Network

Official figures understate true market rates‐ anecdotal evidence of rates in shadow banking system >20% in 2011…

US & Chinese Monetary Aggregates

The PBOC’s perpetual money printing calls into question demand‐based estimates of the value of Chinese currency – China has a greater money stock than the US

14,000.0 35.0% Massive fiscal stimulus – 14% of GDP! (US stimulus – 6%) 12,000.0 30.0% 10,000.0
14,000.0
35.0%
Massive fiscal stimulus – 14% of GDP! (US stimulus – 6%)
12,000.0
30.0%
10,000.0
25.0%
8,000.0
20.0%
US M2
6,000.0
15.0%
China M2,
USD
US YoY
China YoY
4,000.0
10.0%
2,000.0
5.0%
0.0
0.0%

Source: Federal Reserve, PBOC

A sight to humble even Helicopter Ben…

US & Chinese Monetary Aggregates The PBOC’s perpetual money prin ting calls into question demand‐ based

Explicit costs of sterilization:

Spread between costs of special bills and return on foreign assets Size of special bills relative to size of foreign assets

Implicit costs of sterilization:

Lending shifts to ‘shadow’ banking system

Off balance sheet leverage and underground banking system

• Explicit costs of sterilization: • Spread between costs of special bills and return on foreign

Current PBOC Governor Zhou Xiaochuan (周小川)

Distorts capital allocation PBOC balance sheet expansion crowds out consumption

Balance sheet must grow with economy to maintain peg 12/31/10 – PBOC is levered 1,180x! 1

Inflation can only be suppressed temporarily:

Liquidity ‘overhang’ remains on PBOC balance sheet Significant obstacle to deploying reserves domestically

Ultimate adjustment filters through via:

Domestic prices Export sector via resource procurement Significant buyer of commodities

Foreign Exchange Reserves – 1999­2011

3,500 3,000 At 6/31/11 China’s reserves were: 2,500 3.4x 2005 reserves 17.7x 2001 reserves 2,000 1,500
3,500
3,000
At 6/31/11 China’s reserves were:
2,500
3.4x 2005 reserves
17.7x 2001 reserves
2,000
1,500
1,000
500
0
12/1/1999
12/1/2001
12/1/2003
12/1/2005
12/1/2007
12/1/2009

Billions of USD

Source: China Economic Information Network, Bloomberg

1 – PBOC Statistics & Figures 2010

Raising interest rates last resort for PBOC to control inflation:

Raises costs of currency sterilization – deposit rate +1% costs +~5% 1 Attracts speculative capital flows (‘hot’ money) Inflicts losses on banking sector via bond holdings

25.00% 20.00% Household Savings Deposits 1 15.00% Yr. Rate China 1 Yr. Lending Rate 10.00% Deposit
25.00%
20.00%
Household
Savings
Deposits 1
15.00%
Yr. Rate
China 1 Yr.
Lending
Rate
10.00%
Deposit
Reserve
Ratio
5.00%
0.00%

Source: PBOC, Bloomberg

1 – Christer Ljungwall, Christer, Yi Xiong, and Zou Yutong. “Central Bank Financial Strength and the Cost of Sterilization in China”. CERC Working Paper 8 (2009)

Mercantilist trade policy/sterilization has led China to share Japan’s burden of underwriting American profligacy‐ China is a forced buyer:

5000 45.0% 4500 40.0% 4000 35.0% 3500 30.0% US Debt, Held by Foreigners 3000 US Debt
5000
45.0%
4500
40.0%
4000
35.0%
3500
30.0%
US Debt, Held by
Foreigners
3000
US Debt to China
25.0%
2500
US Debt to
Japan
20.0%
2000
China, % of Tot.
15.0%
Japan, % of Tot.
1500
10.0%
1000
5.0%
500
0
0.0%
Mercantilist trade policy/sterilization has led China to share Japan’s burden of underwriting American profligacy‐ China is

Source: US Treasury, billions of USD

China is ~10% of World GDP but its share of global commodity consumption is much higher:

60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Cement Iron Ore Coal Steel Lead Zinc Alumninum Copper
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
Cement
Iron Ore
Coal
Steel
Lead
Zinc
Alumninum
Copper
Nickel
Pork
Eggs
Rice
Soybeans

Source: GMO, 4/11 Quarterly Letter

China’s resource‐intensive growth is stretching global supply… Further growth will prove increasingly costly and pressure domestic prices…

Chinese Consumer Price Indices – 1978 ­ 1998 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% 1978

Chinese Consumer Price Indices – 1978­1998

30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% 1978 1981 1984 1987 1990 1993 1996 -5.0%
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
1978
1981
1984
1987
1990
1993
1996
-5.0%

Source: PBOC, Bloomberg

CPI, YoY CPI, Urban, YoY CPI, Rural, YoY

Previous inflationary surges (late ’80s, mid ‘90s) managed by extraordinary financial repression Total halt of bank lending, sweeping centralization of finance/fiscal authority, etc. Achieved by powerful “core” leaders (i.e. Deng Xiaoping, Zhu Rhongji, etc.) Unclear if current ‘bureaucratized’ apparatus is capable of repeating such drastic action…

Like Asian peers, China has utilized the export growth model:

Arbitrage advantage from low cost labor

20‐35%/GDP from exports Ultimate impact is larger:

Proceeds are levered through state financial system & re‐invested domestically

 

40‐50% of GDP from fixed asset investment

Primary destinations for fixed asset investment 1 :

Export production capacity

 

Real estate

Significant leverage to global demand

Investment increasingly compensating for weak global demand:

~70% of 2008 growth

~90% of 2009 growth 2

• Like Asian peers, China has utilized the export growth model: – Arbitrage advantage from low

China lacks meaningful growth drivers outside of exports and state‐driven investment

• Like Asian peers, China has utilized the export growth model: – Arbitrage advantage from low
  • 1 – Moody’s Analytics Report “China: Fixed Asset Investment”. Published 6/13/2011.

Exports & Gross Capital Formation / GDP – 1981 ‐ 2009

90% 80% 70% 60% Global downturn literally paved over: Gross Cap. Form. (Fixed 50% Asset Investment)
90%
80%
70%
60%
Global downturn literally paved over:
Gross Cap.
Form. (Fixed
50%
Asset
Investment)
40%
Exports
30%
Combined
20%
10%
0%
1981
1986
1991
1996
2001
2006

Source: World Bank

Real estate is another significant destination for fixed asset investment:

HSBC estimates total value of residential property at 3.27x GDP 1 Almost 2x level in US before subprime crisis Close to Japanese peak level of 3.8x

Japanese ‘89 GDP/Capita = 14.4x China ‘09 GDP/Capita (Constant USD)

Price/income levels top global markets at peak of credit cycle

Price/Income – 15‐20x in major cities, ~10x in regional cities 2

9x in London, 12x in Los Angeles in 2007

• Real estate is another significant destination for fixed asset investment: • HSBC estimates total value
• Real estate is another significant destination for fixed asset investment: • HSBC estimates total value

1 – HSBC Global Research Currency Weekly, 06/07/2010, p. 5

Compensating for Something?

More than 100 ‘supertall’ ( >300m) buildings in planning or under construction

Currently only 70 buildings > 300m globally Significant number of projects financed and initiated by local governments

Historically, projects of this scale have marked market tops 1 :

Compensating for Something? • More than 100 ‘supertall’ ( >300m) buildings in planning or under construction

Goldin Finance 117, Tianjin– 117 floors, 597m – under construction. Master plan also calls for 2 70 story towers and residential high­rises

Compensating for Something? • More than 100 ‘supertall’ ( >300m) buildings in planning or under construction

Ping An Insurance’s new Shenzen headquarters – 115 floors, 648m – under construction

Compensating for Something? • More than 100 ‘supertall’ ( >300m) buildings in planning or under construction

The Guangzhou Urban Planning Bureau’s proposed center piece for the planned Baietan CBD – 118 floors, 650+m. The district will have more than 10mm sq. meters of floor space.

For the benefit of American readers, Chicago’s Willis (Sears) Tower is only 527m when its 85m antennae are included…

1 – Andrew Lawrence, ”The Skyscraper Index: Faulty Towers,” Property Report Dresdner Kleinwort Wasserstein Research (1999)

Dubai X 1000?

Tianjin is planning an especially grandiose central business district which is currently under construction:

Dubai X 1000? • Tianjin is planning an especially grandiose central business di strict which is
Dubai X 1000? • Tianjin is planning an especially grandiose central business di strict which is

Construction of Phase 1 of project is underway… The towering building visible at center left is to be ~600m, which would be the world’s second tallest if it stood today

China is in dire need of structural reform:

Dependent on export economy & fixed asset investment

Export impact smaller on a net basis, but provides critical source of foreign exchange

Macro‐economic management distorting capital allocation

Mounting leverage and inflation

Party remains dominant player in business and finance

Utilizes market mechanisms selectively & on its own terms Unwilling to relinquish meaningful authority to markets

• China is in dire need of structural reform: – Dependent on export economy & fixed

Experience of other Asian ‘tigers’ suggests growth will slow irrespective of internal obstacles 1 ‘Middle Income Trap’ – export model has limitations Export & invest model precludes balanced growth & formation of consumer society

Tempting comparisons to Japan but realities of China are even starker…

1 – Barry Eichengreen, Donghyun Park, & Kwanho Shin. “When Fast Growing Economies Slow Down: International Evidence and Implications for China,” NBER Working Paper 16919 (2011)4

Consensus: China will rebalance and replace US as global consumer

McKinsey – Chinese urban middle class with spending power equivalent to Japanese households by 2025 $2.4 trn

Problems recognized, but structural transition taken as a given

Reality: China cannot become a consumer nation without significant structural reform

Govt. recognizes problems but wedded to statist solutions Soft’ infrastructure needed, not more hard infrastructure Current system incompatible with consumer society

State must withdraw from capital allocation

State investment crowds out private entrepreneurs

Investment funded by state banking system, in turn funded by captive capital of private savers

Non‐state sector starved of capital and resources

Capital markets play no meaningful role in capital allocation

PBOC must curtail its market operations

Massive balance sheet expansion crowds out domestic consumption, creates dangerous liquidity overhang

Dividends from export subsidies accrue largely to foreign investors and state‐owned enterprise

• Consensus: China will rebalance and replace US as global consumer – McKinsey – Chinese urban
• Consensus: China will rebalance and replace US as global consumer – McKinsey – Chinese urban

Populace has not shared in gains from growth:

Personal income/ capita severely lags GDP/Capita growth, which itself lags GDP growth 1 Wage squeeze worsened by inflation/asset bubbles

2 nd largest economy, but 93 rd in GDP/Capita IMF

Between Macedonia (92 nd ) & Algeria (94 th ) GDP/Capita overstates income as only ~40% flows through to labor Labor’s slice of the pie is shrinking 2 :

1997 Wages/GDP: 53%

2007 Wages/GDP: 40%

Large wealth inequality

0.4% of Chinese control 40‐50% of wealth 3

– – Gini coefficient: 47 in 2010 according to state ests. 4

Understated, excludes ‘hidden income’

Concentration of wealth reflects concentration of power amongst political elites

How successful can the Chinese miracle be when so few have enjoyed its benefits?

• • • • Populace has not shared in gains from growth: Personal income/ capita severely
• • • • Populace has not shared in gains from growth: Personal income/ capita severely

2008 Avg. Hourly Wage

$16.00 $14.00 $12.00 $10.00 $8.00 $6.00 $4.00 $2.00 $0.00 S. Korea Singapore Brazil Hong Kong Mexico
$16.00
$14.00
$12.00
$10.00
$8.00
$6.00
$4.00
$2.00
$0.00
S. Korea
Singapore
Brazil
Hong Kong
Mexico
China

Source: World Bank Development Indicators, 19752008.

  • 1 A. R. Khan and Carl Riskin, “Income and Inequality in China: Composition, Distribution and Growth of Household Income, 1988 to 1995”, The China Quarterly 154 (1998)

  • 2 – Richard McGregor, The Party (New York: Harper MacMillan) 2010

  • 3 – Victor Shih, “High Wealth Concentration, Porous Exchange Control, and Shocks to Relative Return: The Fragile State of China’s Foreign Exchange Reserve,” Presentation at the Institute of New Economic Thinking, Bretton Woods, NH (2011)

Since the early ‘90s, China’s urban populace has been favored at the expense of their poorer, less educated rural compatriots:

Per capita income 1 :

Urban ‐ $2,000

Rural ‐ $ 605 Limited job opps.‐ 40% of rural population un‐ or underemployed 2 Limited public services in rural areas Cut off from bank credit, reliant on informal credit/loan sharks Function of concentration of wealth/political power in cities

Huoku 户籍) rural/urban class register system exacerbates divide:

Rural citizens literally ‘second class’ citizens with restricted mobility

Creates marginalized class of 150mm migrant rural laborers 3

Rural workers can move to cities to seek jobs, but lack access to basic public services due to rural citizenship

Often forced to work in informal low‐paying jobs Social position analogous to illegal immigrants in the US

• Since the early ‘90s, China’s urban populace has been favored a t the expense of
• Since the early ‘90s, China’s urban populace has been favored a t the expense of

Privatizations of ‘90s dismantled ‘Iron Rice Bowl’ 铁饭碗) social security net:

SOEs used privatizations to jettison low‐productivity workers at firms thought to be ~30% overstaffed 4 Tenured SOE employees had previously enjoyed guaranteed jobs and benefits the ‘Iron Rice Bowl’ Restructuring carried out to enhance profitability of SOEs retained by government Created large group of structurally unemployed– ~1/2 thought to still remain jobless 4 Current government retirement programs available only to urban residents, ~95% funded by local governments 4

  • 1 – Yasheng Huang , Capitalism with Chinese Characteristics: Entrepreneurship and the State (New York: Cambridge University Press, 2008) 251.

  • 2 – Jason Gale & Bret Okeson. “China Doctors Earning $300 a Month Flock to Drug Companies,” Bloomberg Businessweek, 7/10/11.

  • 3 John Bryan Starr, Understanding China: A Guide to China’s Economy, History, and Political Culture, 3 rd Edition (New York: Hill & Wang, 2010) 162.

Local governments now responsible for education, healthcare, and social security after late ’80s ‘reforms’:

Created problematic conflicts for local leaders with significant social consequences:

New responsibilities were unfunded mandates

Local officials’ performance still assessed by nominal growth:

 

Incentivized to favor short term economic growth over long‐term social investment

Increasing demands on local leaders paid for through unsustainable financing practices:

Local governments allowed to run budget deficits in 2008

Local government debts already ~25%/GDP by year‐end 2009! 1

Incentive structure promotes short term‐ism in local finance Sales of expropriated prop. frequently used to fund budget gaps Arbitrary seizures of peasant farmland, property re‐sold to developers by local government

70mm farmers have lost their land in this way in the past decade! 2

Aggrieved citizens have little recourse as local governments’ word is law:

Seeking justice higher up the state hierarchy difficult and dangerous

1% of petitions for redress to government resolved satisfactorily 3

• Local governments now responsible for education, healthcare, and social security after late ’80s ‘reforms’: •
• Local governments now responsible for education, healthcare, and social security after late ’80s ‘reforms’: •
  • 1 Anthony Chan “China’s Hidden Domestic Public Debt: Some Perspective on the Risks it Poses”, AllianceBernstein Global Economic Research Report (2010)

  • 2 Starr, 176.

Healthcare

2000 World Health Organization study ranked China’s healthcare system 144 th globally 1

Behind Burundi 143 rd , ahead of Mongolia 145 th

~40% of sick rural residents did not seek medical care due to its unaffordability 2 ~60% of rural residents requiring hospitalization did not seek treatment due to unaffordability 2 1 public health professional / 7,000 people US – 1/635 3

• Healthcare – 2000 World Health Organization study ranked China’s healthcare system 144 globally • Behind

Education

State withdrew education funding in ‘90s

Expense dumped on local govts. and subsequently passed on to parents in form of increasing school fees

Education costs grew faster than CPI by 10% in ’90s 4 Inequality continues to rise: 5

Lack of training drives inequality in wages 6

Illiteracy increased 64.3% between 2000 and 2005

Equivalent to 30% of rural school cohorts from 1990s 7

Rural secondary school dropout rates – 43% in ’00‐’03 8

• Healthcare – 2000 World Health Organization study ranked China’s healthcare system 144 globally • Behind

Patients awaiting treatment

  • 1 – World Health Organization. World Health Report 2000.

  • 2 – Yasheng Huang , Capitalism with Chinese Characteristics: Entrepreneurship and the State (New York: Cambridge University Press, 2008) 251.

  • 3 – Jason Gale & Bret Okeson. “China Doctors Earning $300 a Month Flock to Drug Companies,” Bloomberg Businessweek, 7/10/11.

  • 4 – Carsten Holz, “China’s Economic Growth 19782025: What We Know Today About China’s Economic Growth Tomorrow” Hong Kong University of Science & Technology, 2005.

5– Ravi Kanbur & Xiaobo Zhang, “Fifty Years of Regional Inequality in China: A Journey through Central Planning, Reform, and Openness”, Review of Developmental Economics 9 (2005) 6– Z. Liu, “The Effects of Economic Reforms on Wage Inequality: Some Evidence from China,” Applied Economics Letters, 8, (2001)

  • 7 – Huang, 43

II. Banking & Finance
II. Banking & Finance

Chinese finance speaks to the fundamentally poor prospects for structural transition without reform:

China’s growth is largely internally financed

FDI is limited & largely focused on export industries i.e. offshoring/outsourcing

High savings rate finances investment glut

Savers unwillingly underwrite growth

• Chinese finance speaks to the fundamentally poor prospects for structural transition without reform: • China’s

Banking sector provides cheap capital for SOEs, local govts.

State sets interest rates and limits investment options for savers

Fixed deposit rates, fixed lending rates Fixed NIM Creates cheap, captive capital for state banks Real deposit rates frequently negative

De facto tax on Chinese savers

– – Alternatives for savers restricted to stocks, RE

Encourages speculation, distorts asset prices

Shifts investment to unregulated shadow banking system

• Chinese finance speaks to the fundamentally poor prospects for structural transition without reform: • China’s
60.00% 50.00% 40.00% FDI, % of GDP 30.00% Gross savings, % 20.00% of GDP 10.00% 0.00%
60.00%
50.00%
40.00%
FDI, % of
GDP
30.00%
Gross
savings, %
20.00%
of GDP
10.00%
0.00%
1982
1987
1992
1997
2002
2007

Source: PBOC, Bloomberg

“In our country’s current level of macroeconomic development, we must maintain a level of macroeconomic growth
“In our country’s current level of macroeconomic development, we must maintain a level of macroeconomic growth
“In our country’s current level of macroeconomic development, we must maintain a level of macroeconomic growth

“In our country’s current level of macroeconomic development, we must maintain a level of macroeconomic growth of around 8% per annum and this will inevitably require a corresponding level of capital investment. Our country’s financial system is primarily characterized by indirect financing (via banks); the scale of direct financing (via ca pital markets) is limited.”

– Yang Kaisheng (杨凯生), CEO of Industrial & Commercial Bank of China 1

Capital Raising Activity – 1993 ­ 2009 100% 90% 80% 70% 60% Bonds 50% Bank Loans

Capital Raising Activity – 1993 ­ 2009

100% 90% 80% 70% 60% Bonds 50% Bank Loans 40% Equity 30% 20% 10% 0% 1993
100%
90%
80%
70%
60%
Bonds
50%
Bank Loans
40%
Equity
30%
20%
10%
0%
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009

Source: PBOC Financial Stability Report 2010

The subsidized domestic banking system finances almost all economic activity 1 :

Bank loans & bonds account for ~90% of corporate finance 1 Equity financing ‐ immaterial Foreign banks ‐ 2% of financial assets 2 Keeps capital market exposure to a minimum

1 – Saez, Lawrence, “Banking Reform in China and India,” (New York: Palgrave Macmillan, 2004) 2– Carl Walter & Frasier Howie, “Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise,” (New York: John Wiley & Sons, 2011)

China’s reliance on its state banking system is understated as corporate bonds are not materially distinguishable from bank loans :

70% held to maturity by state banks 1 22 of 24 primary dealers are state banks 1

Underwriting bond and retaining credit risk– effectively a loan

The Chinese yield curve is a construction of the state:

Uses state‐set bank 1 year deposit‐rate as a baseline Trading volume is insignificant – yield curve can be drawn arbitrarily

• China’s reliance on its state banking system is understated as corporate bonds are not materially

Bonds issued and sold primarily to government‐controlled entities:

Sold at below market coupons Selling unattractive for holders

Creates losses due to below‐market issuance; politically unappealing

Illustrative of Party ’s superficial adoption of market institutions:

Structure adopted to maximize party ’s ability to limit the impact of market forces Institutional character informed by earlier experiences with retail bond market

The banking system is China’s de facto second treasury:

Capital allocation system fundamentally unchanged since ‘70s

Party views banking system as policy tool and as a vehicle for personal enrichment

o Capital is often politically directed and used by local officials to accomplish the party’s economic targets

o Senior bank officials & SOE managers selected by

nomenklatura system

o Party retains majority equity ownership & ultimate control

The Party controls the banking system

• The banking system is China’s de facto second treasury: • Capital allocation system fundamentally unchanged
• The banking system is China’s de facto second treasury: • Capital allocation system fundamentally unchanged

The banking system funds almost all economic activity

We now will briefly review the current state of Chinese banking:

Corporate banking in China is dominated by 4 large state‐controlled banks The ‘Big 4’ and their emerging rival BoCom:

• Corporate banking in China is dominated by 4 large state‐controlled banks The ‘Big 4’ and

Primary tools of state in managing the economy:

A ‘second treasury’ Despite purported commercialization and public listings govt. influence remains significant Credit frequently extended on the basis of personal relationships rather than perceived creditworthiness

• Corporate banking in China is dominated by 4 large state‐controlled banks The ‘Big 4’ and
• Corporate banking in China is dominated by 4 large state‐controlled banks The ‘Big 4’ and

Listed with share of domestic financial assets as of 12/31/10 1 :

Bank of China BOC

17.0%

China Construction Bank CCB

17.6%

Industrial & Commercial Bank of China ICBC 21.9%

Agricultural Bank of China ABC

16.8%

Bank of Communications BoCom Emerging rival to Big 4

6.4%

• Corporate banking in China is dominated by 4 large state‐controlled banks The ‘Big 4’ and
• Corporate banking in China is dominated by 4 large state‐controlled banks The ‘Big 4’ and

Initially formed as state policy banks, later commercialized in early/mid ‘90s Politicized – government. retains majority ownership and controls boards of directors; personnel must be government approved

79.7% of domestic financial assets

1 – Bank annual reports, various, PBOC Annual Survey & Statistics 2010.

“If it doesn’t have access to a stable and sufficient source of capital, the China Development

“If it doesn’t have access to a stable and sufficient source of capital, the China Development Bank will be unable to operate normally”

‐ Anonymous, Treasury Department, CDB. Quoted 01/11/10 in The Economic Observer (经济观察报)

The core of the banking system is rounded out by the explicitly statist policy banks:

Listed with share of domestic financial assets as of 12/31/10 1 :

China Development Bank CDB

8.3%

Agricultural Development Bank of China ADB 2.8%

China Import‐Export Bank CIE

1.4%

China Postal Savings Bank CPSB

Undisclosed

Formed in 1994 to take over policy loans from newly commercialized Big 4 as part of larger fin. sector restructuring

Despite stated mission, majority of activity is indistinguishable from operations of ‘commercialized’ Big 4

Policy Banks ex. CPSB ‐ 12.6% of total financial assets

Big 4 BOCOM Policy Banks ex. CPSB 92.3% of total financial assets

Concentration has increased in past decade Centralization of finance aids and abets party control

1 – Bank Annual Reports, PBOC.

“If it doesn’t have access to a stable and sufficient source of capital, the China Development
“If it doesn’t have access to a stable and sufficient source of capital, the China Development
China Development Bank (CDB) • Particularly important in recent years: • Led by Revolutionary ‘princeling’ –
China Development Bank (CDB)
• Particularly important in recent years:
• Led by Revolutionary ‘princeling’ – son of
China’s former supreme state planner , Chen Yun
• Lending vol. on par with Ministry of Finance
• 12/31/2010 loan book 2X World Bank’s
•Sovereign wealth fund, but majority of
investment is domestic
• 70% funded by commercial banks (Big 4)
• Shift to ‘universal bank’ strategy has led state
competitors to similarly diversify business lines
•Introduced new securitized products
•Exemplifies expansion and ambition of state‐
controlled financials
• Financier of state ego projects
• Three Gorges Dam, Shanghai Pudong Aiport,
Beijing Olympic projects, etc.
5- Year Asset CAGR ROA RE Loans / OBS Commitments NPL Tier 1 Total Loans /
 

5- Year Asset CAGR

ROA

RE Loans /

OBS Commitments

NPL

Tier 1

 

Total Loans

/ Total Loans

Ratio

Capital

Commercial Banks

Bank of Communications

22.7%

1.1%

9.8%

75.5%

1.1%

9.2%

China Construction Bank

18.7%

1.4%

8.9%

44.0%

1.3%

10.3%

Bank of China

17.2%

1.1%

29.1%

84.2%

1.2%

10.0%

Agricultural Bank of China

16.7%

1.0%

26.6%

14.1%

2.3%

9.6%

Industrial & Commercial Bank of China

15.8%

1.3%

27.0%

54.3%

1.2%

9.7%

Policy Banks

China Development Bank

21.9%

0.8%

N/A

N/A

0.6%

N/A

Agricultural Development Bank

15.5%

N/A

N/A

N/A

1.1%

N/A

Export-Import Bank

44.9%

N/A

N/A

N/A

N/A

N/A

Postal Savings Bank

N/A

N/A

N/A

N/A

N/A

N/A

 

Commercial Bank Average:

18.2%

1.2%

20.3%

54.4%

1.4%

9.8%

Policy Bank Average:

27.4%

N/A

N/A

N/A

0.9%

N/A

Average:

21.7%

1.1%

20.3%

54.4%

1.3%

9.8%

CDB figures as of 12/31/09 (most recent), NPL figure reflects provision for loan losses as NPLs are undisclosed. Export-Import Bank figures as of 12/31/09 (most recent). All other figures as of 12/31/10

With aggressive loan growth and weak cash flow generation, Chinese banking is unusually capital intense and requires constant refreshment….

Equity Offerings & Dividend Payouts, ‘Big 4’ Banks, 2005­2010

400,000 300,000 200,000 100,000 Proceeds from Sale of Common Stock Dividends Paid 0 2005 2006 2007
400,000
300,000
200,000
100,000
Proceeds from
Sale of Common
Stock
Dividends Paid
0
2005
2006 2007
2008 2009
2010
(100,000)
(200,000)
(300,000)

Source: Bloomberg, Bank annual reports

…And yet, >50% of ‘05‐’10 & 95% of ‘07‐’10 new equity capital paid in dividends!

This oddity is more explicable when we recall that vast majority of bank dividends accrue to the state…

70,000 60,000 50,000 40,000 Domestic Credit Credit is growing faster than GDP… GDP 30,000 20,000 10,000
70,000
60,000
50,000
40,000
Domestic Credit
Credit is growing faster than GDP…
GDP
30,000
20,000
10,000
0
Dec-99
Nov-00
Nov-01
Nov-02
Nov-03
Nov-04
Nov-05
Nov-06
Nov-07
Nov-08
Nov-09
Nov-10

Source: PBOC, Bloomberg, billions of RMB

Loan growth has slowed but remains dangerously high…

40.0% 10.0% 9.0% 35.0% 8.0% 30.0% 7.0% Total Loans of Fin. Institutions, YoY (L. Axis) 25.0%
40.0%
10.0%
9.0%
35.0%
8.0%
30.0%
7.0%
Total Loans of
Fin. Institutions,
YoY (L. Axis)
25.0%
6.0%
20.0%
5.0%
4.0%
15.0%
NPL Ratio (R.
Axis)
3.0%
10.0%
Stimulus wall: banks given green light for growth:
2.0%
5.0%
1.0%
0.0%
0.0%
Dec-05
Jun-06
Dec-06
Jun-07
Dec-07
Jun-08
Dec-08
Jun-09
Dec-09
Jun-10
Dec-10

Source: PBOC, Bloomberg

NPLs appear minimal but are a backward‐looking indicator in a loose credit environment…

China’s state financial system has historically fared poorly & has an unfortunate track record 1 :

2 major events since 1978:

Late ’80s / Early ‘90s

Provincial governors controlled PBOC branches Local officials overcook growth 20+% inflation Inflationary spike forced total halt of bank lending Sparked ‘hard landing’ ‐ real estate crash in Hainan

Late ‘90s / Early ‘00s

Induced by Asian Financial Crisis (AFC) Unresolved NPLs from previous crisis compounded impact of new wave of bad loans – 40% of pre‐2000 loans bad! 2 Govt . response led to current market structure

Historical recovery rates in the 10­20% range on bad loans Compare to recoveries ~60% at peak of US S&L Crisis

Suggests lack of true profit motive in lending, likelihood of fraud and theft at the margin Without external shocks (i.e. AFC) state can delay reckoning indefinitely

Incomplete reforms

Previous crises resolved by creative accounting topped up with small infusions of forex reserves and capital raised from IPOs Perceived success of bank recaps. and subsequent collapse of Western financial system has reduced perceived need for reform

1 Victor Shih, “Factions & Finance in China: Elite Conflict and Inflation,” (New York: Cambridge University Press, 2007 2 – Walter & Howie

• China’s state financial system has historically fared poorly & has an unfortunate track record 1
• China’s state financial system has historically fared poorly & has an unfortunate track record 1

GITIC – Forerunner of today ’s banking sector?

Engaged in practices common in modern Chinese finance i.e. off balance sheet vehicles, growth of non‐core business lines, politicized lending First and only Chinese financial allowed to fail

Lender and securities co. effectively controlled by local government

Hong Kong listed subsidiary issued bonds in US

Govt . provided ‘comfort letters’ for GITIC’s international deals

Explicit assurance that state stood behind the bank

Enormous expansion in ‘90s aided by Western banks

One of China’s first international players

Went bust in wake of Asian financial crisis – January 1999

NPL ratio:

90.0% 1

Recovery rate: 12.5% 1

First and only bankruptcy of major Chinese financial:

Assets: $2.6 bn Claims: $5.6 bn $4.7 bn to foreign creditors

• GITIC – Forerunner of today ’s banking sector? • Engaged in practices common in modern

GITIC’S former headquarters; 3 rd tallest building in Asia at time of construction

International exposure prompted larger concern regarding China’s solvency Necessitated immediate action and a transparent liquidation process:

Appointed KPMG to build credibility with westerners

1 – Thomas Bottini, “Bankruptcy Perils in China: The GITIC Tale,” Multinational Business Review 115 (2003)

Prior to GITIC, the PBOC closed failing banks and made foreign creditors whole:

Comparatively small scale of financial sector and limited international exposure allowed govt . to easily settle the bill PBOC ‘put’ reflected in bond risk:

8 mos. before collapse, GITIC bonds yielded just 240 bps over Treasuries 1

Under banking law, banks were required to register debts to foreigners with govt .

Intended to protect foreign creditors; unregistered debt unenforceable GITIC used Hong Kong subsidiaries to hide overseas debts Diversified into wide variety of operating businesses: 2

Manufacturing, textiles, hotels, etc.

Originally thought to have 66 domestic and 66 overseas subs. 105 domestic and 135 overseas subs. uncovered

Scale of debts led to closures of many trust companies and recentralization of Big 4 under central government’s control

Post‐GITIC reforms sought to re‐centralize control over the financial system Not about enhancing capital allocation No intention of allowing truly private banking or floating interes t rates

1 – Walter & Howie 2 – Bottini

While the provincial GITIC was allowed to fail, China pursued more ‘innovative’ solutions to resolving the banks under the direct control of the central government in the late ‘90s / early ‘00s

Particularly important to the recapitalization and underpinning China’s financial system are the 4 asset management cos. AMCs :

While the provincial GITIC was allowed to fail, China pursued more ‘innovative’ solutions to resolving
While the provincial GITIC was allowed to fail, China pursued more ‘innovative’ solutions to resolving
While the provincial GITIC was allowed to fail, China pursued more ‘innovative’ solutions to resolving
While the provincial GITIC was allowed to fail, China pursued more ‘innovative’ solutions to resolving

China’s 4 AMCs: Orient, Huarong, Great Wall, and Cinda

‘Bad banks’ used to remove problem loans from bank balance sheets Created to deal with primarily late ‘80s/early ‘90s vintage NPLs that remained from past crises:

Govt. delayed resolution until exogenous shock of AFC demanded action 40% of pre‐2000 loans non‐performing 1 AMCs acquired RMB 2.4trn of bad loans to recapitalize financial system

AMCs funded by PBOC ‐ AMCs purchase NPLs at face value ‐ 100¢’s on the dollar AMCs resemble developed world bad banks i.e. RTC in US S&L crisis , but critical difference:

Banks received AMC bonds – an unfunded receivable – no cash into banks Accounting solution; banks retain exposure to bad loans

1 – Walter & Howie

Intended as temporary institutions, the AMCs’ 1999 mandate was renewed in 2009 for a further 10 years:

Thinly capitalized; inevitably insolvent

Negligible capital base and inflated purchase price of loans made profitable operation impossible from the beginning Significant operating expenses exacerbated dearth of loan recoveries ~11% by ‘05 1,2 Government has had to provide ‘comfort letters’ to auditors to assure solvency

More recently the elegant AMC system has been abandoned in favor of direct issuance of unfunded receivables by the Ministry of Finance MOF :

Mechanics remain the same; banks receive unfunded, evergreen IOUs

AMC bonds and subsequent MOF receivables are significant state liabilities not reflected in headline sovereign debt figures

  • 1 – Shih (2007), 174

• Intended as temporary institutions, the AMCs’ 1999 mandate was renewed in 2009 for a further

AMCs like Cinda have opportunistically used the licenses of their seized portfolio companies to enter a wide variety of business lines, significantly expanding beyond their original mandate:

Seized operating businesses continue as going concerns

• AMCs like Cinda have opportunistically used the licenses of their seized portfolio companies to enter
• AMCs like Cinda have opportunistically used the licenses of their seized portfolio companies to enter
• AMCs like Cinda have opportunistically used the licenses of their seized portfolio companies to enter
• AMCs like Cinda have opportunistically used the licenses of their seized portfolio companies to enter
• AMCs like Cinda have opportunistically used the licenses of their seized portfolio companies to enter
• AMCs like Cinda have opportunistically used the licenses of their seized portfolio companies to enter
• AMCs like Cinda have opportunistically used the licenses of their seized portfolio companies to enter
• AMCs like Cinda have opportunistically used the licenses of their seized portfolio companies to enter
• AMCs like Cinda have opportunistically used the licenses of their seized portfolio companies to enter
• AMCs like Cinda have opportunistically used the licenses of their seized portfolio companies to enter

Employ 12,000 people

A selection of some of Cinda’s publically acknowledged subsidiaries

Bad banks now diversified conglomerates

Operating losses worsen already weak financial position

Cinda’s subsidiaries span life insurance, P&C insurance, securities brokerage, equipment finance, futures trading, investment management, real estate investment, trust management, property development, construction, and even include industrial businesses.

AMC bonds and later MOF receivables comprise a significant portion of the Big 4’s capital base:

Bonds rolled with AMC mandate

Evergreen NPLs:

Oldest underlying loans reportedly date to late ’80s and early ‘90s Continued presence on bank balance sheets speaks to ‘kick the can’ approach to restructuring

Banking system rests on shaky foundation of accounting trickery

Investors aware of potential balance sheet holes but believe in PBOC/MOF ‘put’ Assumption that state will be able to replicate GITIC restructuring

Big 4 Banks - Big Balance Sheet Holes

in billions of RMB

BOC

CCB

ICBC

ABC

1998 MOF Bond

42.5

49.2

85.0

93.3

1999 AMC Bonds

160.0

247.0

313.0

0.0

2007 MOF Receivable

0.0

0.0

62.3

635.5

2004 PBOC Special Bills

0.8

63.4

434.8

0.0

2006 PBOC Target Bills

113.5

0.6

0.0

0.0

2007 PBOC Bills and Bank Sub-Debt

14.6

57.1

237.1

0.0

Total:

331.4

417.3

1,132.2

728.8

Total Assets:

8,748.2

9,623.0

11,785.1

8,882.6

Total Capital:

608.3

492.0

586.4

342.8

AMC Bonds/Total Capital:

26.3%

50.2%

53.4%

-

Source: Audited financial statements. 12/31/2009 values.

AMC bonds and later MOF receivables comprise a significant portion of the Big 4’s capital base:
AMC bonds and later MOF receivables comprise a significant portion of the Big 4’s capital base:

Confidence in the banking system reflects investor confidence in the ability of the state to recapitalize financial system – large forex reserves provide illusory comfort…

th

The PBOC even has its own ‘bad bank’ used to hide debts & disguise its probable insolvency:

Huida Asset Management Created in 2005 in order to remove problem loans from PBOC balance sheet

Funded by Cinda Asset Management Co.

Utilized due to close political ties to PBOC

Opaque, no disclosure on operations as portfolio has not been marketed to outside investors, in contrast to more transparent 1 st generation AMCs

Official documents suggested Huida was to acquire real estate loans from Hainan/Guangxi and portfolios from the GITIC bankruptcy mid‐late ’90s vintages :

Belief among market participants is that Huida instead acquired the PBOC’s original AMC loans in order to ease pressure on insolvent AMCs 1

This would imply a ‘round‐trip’ investment that would offset and disappear if the entities were consolidated

Unaudited, off balance sheet vehicle for PBOC and Cinda

Unlisted and unmentioned on Cinda’s website; fiscal ‘black hole’ 1

1 – Walter & Howie

State‐Owned Assets Supervision & Administration Commission (SASAC) State Council PBOC Ministry of Finance Central SAFE Investment
State‐Owned Assets
Supervision & Administration
Commission
(SASAC)
State Council
PBOC
Ministry of
Finance
Central SAFE
Investment
Financial Regulatory
Soup (NDRC, CBRC,
CSRC, CIRC)
Asset Management
China Investment
Corp. (CIC)
Cos. (Huarong, Orient,
Great Wall, Cinda, Huida)
SOEs
Central Huijin
Investment
‘Big 4’ and China
Development Bank

The Ministry of Finance, operating directly under the State Council, lies at the heart of the contemporary Chinese financial system:

The PBOC has been relegated to a secondary role after suffering a significant erosion of its power in the early/mid ‘00s PBOC formerly controlled Big 4 & CDB via Central SAFE Investment

Divisions between the PBOC & MOF reflect alternate career paths within the party 1 :

MOF dominated by generalists: Typically rotated between ministries and localities Historically has favored de‐centralization of financial control, economic growth over price stability/social welfare

PBOC dominated by Technocrats: Typically advanced through ‘silo’ hierarchy of PBOC Historically has favored centralization of finance and prioritized price stability

Regulatory reform has been hampered by internal conflicts between the treasury MOF and the central bank PBOC

This conflict is reflected in the country’s dueling sovereign wealth funds SWFs :

China Investment Corporation CIC Central SAFE Investment SAFE

Regulatory reform has been hampered by internal conflicts between the treasury MOF and the central

The nondescript entrance to MOF headquarters in Beijing

The current ownership & regulatory structure of China’s financial system is the product of still‐born reform:

PBOC led reform and restructuring process in late ‘90s/early ’00s Instituted AMC system & initiated IPOs of Big 4 in Hong Kong PBOC intended to proceed with further privatization and financial liberalization MOF acted opportunistically to seize control of most important levers of power before the PBOC’s reforms could be completed

MOF’s political ascendancy strongly reduced the likelihood of further reform

We now briefly review the political struggle between the PBOC/MOF:

Perceived success of restructuring via AMCs impeded further reform:

Media outcry after subsequent sales of minority stakes in prized state assets to foreigners

 

9% of CCB sold to Bank of America, 5% to Temasek Singaporean SWF

 

Media consensus: if the banks had just been successfully recapitalized, why sell to foreigners? 1

Exacerbated already hostile elements in the MOF and other rival state ministries stemming from the PBOC’s independent creation of a commercial paper CP market: 2

PBOC had previously ceded regulatory power over fixed income to the State Planning Commission Creating CP market undermined this authority, generated resentment amongst political rivals

Sudden death of PBOC supporter Huang Ju from pancreatic cancer in 2007 shifted balance of power towards MOF:

Prominent supporter of Jiang Zemin and the ‘Shanghai clique’, sworn enemy of Hu Jintao

Politburo Standing Committee member – one of the most influential politicians in China

Had favored centralization and supported PBOC in its reform/centralization efforts

Reflects significant influence of individual politicians in determining critical policy outcomes

Party committee granted MOF approval in 2007 to found China Investment Corporation CIC , a SWF to rival SAFE, the PBOC’s existing sovereign wealth fund:

MOF had blamed PBOC for rising inflation, accused it of poor management of reserves 3

1, 2 – Walter & Howie, 1718 3 – Ibid, 131

It is through CIC that the MOF has enforced its dominance over the PBOC and taken control of the state banks 1 :

Central SAFE Investments SAFE

Created by PBOC to top off Big 4 with foreign exchange reserves in tandem w/AMC bonds

2003 ‐ $45 bn to CCB/BOC 2005 ‐ $15 bn in ICBC

Filled remainder of gap too large to be plugged by accounting gimmicks i.e. AMC bonds Former controlling shareholder of Big 4, majority representation on boards of Big 4/CDB via Huijin Investment Huijin

China Investment Corporation CIC

It is through CIC that the MOF has enforced its dominance over the PBOC and taken

Funded by RMB 1.55 trn Special Bond sold by MOF to PBOC in 2007 PBOC then forced these below market coupon bonds on banks MOF used proceeds to buy $200 bn in foreign exchange reserves from PBOC

USD reserves used to capitalize CIC ~1/3 of proceeds used for SWF investment Remainder used to recapitalize ABC/CDB and to purchase Huijin and by extension the Big 4 & CDB from PBOC

After CIC’s acquisition of Huijin, MOF directly controls Big 4 and CDB Banking system is now directly owned by state treasury

1 Walter & Howie, 127138

III. Party & State
III. Party & State

“The last thirty years have been great on one level. The economy has advanced, but culture, society, and politics have not. In essence, it is the same old system.”

– Wang Xiaofang, former party bureaucrat 1

The party not only retains significant influence in allocating capital but continues to dominate industry by favoring state‐owned enterprise and influencing personnel appointments

Western consensus: Direction of reform since 1978 has remained constant

Gradual reform and liberalization; increasing embrace of private economy and market mechanisms amidst a dismantling of Stalinist central‐planning apparatus

Reality: Many structural reforms have largely been reversed post‐Tiananmen

Incremental reform has occurred, but efficacy is limited by govt.’s distrust of unrestricted market mechanisms and by the ability of vested interests to circumvent reforms at the local level

Understanding the political dynamic since 1978 is critical to understanding the current and future direction of reform:

We briefly review the structure of the Chinese government before summarizing the decades since reform:

1 – Hongru Liu, “The Formation of the Thinking and Reform Proposals for China’s Financial System Reforms”, 2000.

China has been ruled by the Communist Party of China since 1949:

The Party exists above the law and the government:

True locus of political and economic power Authority of the party supersedes all others

Accordingly, prominent politicians typically hold concurrent ro les within government and party:

e.g. Hu Jintao is both General Secretary of the Communist Party of China and President of the People’s Republic of China

• China has been ruled by the Communist Party of China since 1949 : • The

The Hammer & Sickle of the Party

Party retains power of appointment while party agencies i.e. Central Organization Dept. et. al. monitor performance of appointed officials

Party led by 25‐person Politburo

Nominally appointed by Party Central Committee but self‐perpetuating in practice Agenda dictated by General Secretary, decisions achieved by consensus Meets monthly

The Politburo is in turn dominated by the Standing Committee of the Politburo:

Consists of 9 most powerful members of Politburo– China’s ‘board of directors’ Members represent all major policy areas The contemporary standing committee is increasingly structured to check the excesses of individual personalities/offices, i.e. the dictatorial power of the general secretary “Collective wisdom” of committee replaces “core” leaders e.g. Deng Xiaoping, Jiang Zeming Thought to meet on a weekly basis

Unrestricted by the rule of law, Chinese government is inefficient and inequitable:

China’s constitution is a “mission statement” rather than a legal document 1 :

4 versions since ‘49, most recent version adopted ~30 years ago and modified 4 times subsequently

Unpredictable policy environment with frequently changing rules & degrees of enforcement

Without checks and balances & effective enforcement mechanisms, policy making & implementation are frequently indistinguishable

Regulatory structures often reflect internecine political conflicts i.e. MOF vs. PBOC

China’s government is not a federal system: 2

• Unrestricted by the rule of law, Chinese government is inefficient and inequitable: – China’s constitution

Petitioners plead for relief from the corruption of local officials

The government relies on negotiated relationships between a large number of individual politicians, agencies, and organizations:

Particularly marked in relationship between central and local governments

Policy is ad‐hoc and negotiable as central govt. has limited ability to enforce policy at local level Ability of local govts. to negotiate concessions from central govt. reflected in 10,000 ‘liaison’ offices i.e. local government lobbies in Beijing – A ‘Chinese K Street’ 1 Powerful local leaders can run jurisdictions as personal fiefs i.e. Shanghai ‘Clique’ in ‘90s, Chongqing in ‘00s Abuses can only be stopped by concerted effort from center i.e. corruption scandals/scapegoating of problematic officials via Central Committee for Discipline Inspection

  • 1 Starr, 60

  • 2 Starr, 64

Nominally 3 branches of government:

Executive – State Council

Source of power and authority

Composed of heads of 26 state commissions and ministries i.e. Ministry of Finance, Ministry of Railways, Ministry of State Security, etc.

 

State ministries thought to employ 10mm bureaucrats

Complicated management structure ‐ local bureaus report to local govts. as well as to ministry/commission senior office

 

Further hinders efficient regulation/administration/ enforcement of localities by the center

Judicial – Supreme People’s Court

No real independent power – exists solely to apply party policy to specific cases/incidents

Legislative – National People’s Congress

Historically a rubber stamp legislature, conceived of primarily as an arena where regional delegates could come to learn and understand the mass/party line

Delegates now acting with increasing independence i.e. abstaining from votes/voting in dissent , but still without any real independent legislative authority

• Nominally 3 branches of government: – Executive – State Council • Source of power and
• Nominally 3 branches of government: – Executive – State Council • Source of power and

The view from the top

In the absence of a strong federal government, the edicts of the State Council & the larger party superstructure filter through the largely‐ independent hierarchy of local governments:

 

Political capital of local officials determines relative independence from

center and other govt. bodies Officials at one level control the level immediately below them via:

 

Power of appointment Power to draft budgets and levy taxes

Control over the allocation & redistribution of resources

Shanghai Municipal Government Building

Since 2008, permitted to run fiscal deficits:

   

Local officials incentivized to generate short term growth at all costs Debts already est. at RMB 10.7 trn by central govt. in June 2011 1, 2

23 provincial governments, further divided into:

 

300 Prefectures including numerous prefecture level city govts.

~2,9000 Counties Avg. pop. of ~500k

~650 Cities – further disaggregated into:

 

~175,000 Townships 950,000 Villages

Countless Districts, Neighborhoods, and ‘Units’ danwei’

Each of these units exists in various forms, reflecting the ad‐hoc and irregular structure of local governments:

1 – “Fitch Warnds Over China Local Government Debt” BBC News, 09/08/11. Accessed 09/27/11. http://www.bbc.co.uk/news/business14836386

People’s Grand Hall in Chongqing, seat of the local municipal government

  • 2 Yin Nongzhing, Deputy Director of Finance Committee, National People’s Congress stated that RMB 10 trn was a ‘conservative estimate’ of local government debt. Quoted in interview with Reuters, 02/02/11. Accessed 8/23/11.

http://www.reuters.com/video/2011/02/02/chinafacingahiddendebtcrisis?videoId=183875158

Dire need for reform in aftermath of Cultural Revolution

Economy in tatters, party’s credibility shot after bloodbath led by ‘Red Guards’

China came closest to achieving legitimate market‐oriented reform in the ’80s:

Zhao Ziyang and Hu Yaobang led pragmatic reform movement

Disciples of Deng Xiaoping, rose through Communist Youth League

Every single important political reform occurred in the 1980s 1

Mandatory retirement of officials, reform of Party Congress, legal reforms, etc. Efforts to increase administrative autonomy of local governments

Allowed private credit & floating interest rates

Permitted limited private banking with state banks benchmarked against private financials

Party briefly flirted with relinquishing control over capital allocation

Reform and subsequent growth predominantly rural

Areas most affected by Great Leap / Cultural Revolution led reform

Driven by pragmatic local officials who frequently were acting independently of the center, particularly in the poorest provinces

Cities remained dominated by SOEs and central planners

• Dire need for reform in aftermath of Cultural Revolution – Economy in tatters, party’s credibility
• Dire need for reform in aftermath of Cultural Revolution – Economy in tatters, party’s credibility

Zhao (top) & Hu – Architects of reform

• Town & Village Enterprises TVEs led rural growth spurt : – Led by private entrepreneurs,
• Town & Village Enterprises TVEs led rural growth spurt : – Led by private entrepreneurs,
• Town & Village Enterprises TVEs led rural growth spurt : – Led by private entrepreneurs,
• Town & Village Enterprises TVEs led rural growth spurt : – Led by private entrepreneurs,

Town & Village Enterprises TVEs led rural growth spurt :

Led by private entrepreneurs, who were given significant access to credit from localities and Rural Credit/Finance Cooperatives RCCs/RFCs

RCCs – ~75% of agricultural loans, ~50% of all loans to TVEs

Despite Western academic consensus Stiglitz et. al. , successful TVE’s were privately owned & controlled:

Output, profit, and wages of private TVEs 50‐70% higher than state managed TVEs 1

Local govts. subsequently expropriated best private assets in ‘90s

Economic growth matched by welfare gains for majority of population

Rural household income 12.2% real growth from ‘78‐’88 2

  • 1 – Qisong Lin, “Private Enterprises: Their Emergence, Rapid Growth, and Problems,” In China’s Rural Industry, edited by William A. Byrd. (Oxford: Oxford University Press, 1990) 181.

A Brilliant Idiot: Nian Guangjiu founded ‘Idiot’s Seeds’ sunflower seeds in 1982 and is representative of
A Brilliant Idiot:
Nian Guangjiu founded
‘Idiot’s Seeds’ sunflower
seeds in 1982 and is
representative of the
dynamic entrepreneurial
class that emerged as the
state loosened its grip.
Nian was one of the
greatest TVE success
stories of the reform era,
earning a 1mm RMB
profit in 1986. In the ‘90s
he was jailed while his
business was seized and
subsequently run into the
ground by the provincial
government.

Inflationary surge & subsequent aggressive monetary tightening , rising youth unemployment culminated in Tiananmen

Jarring for regime but broader unrest was limited due to material prosperity of rural citizens under ’80s reforms

Tiananmen and subsequent leadership changes led to many reforms being reversed in the 1990s

Hu Yaobang forced out in ’86 following support of student protests; his death in ‘89 was a partial trigger for Tianamen

Zhou Ziyang purged for supporting Tiananmen students

Replaced by Jiang Zeming/Zhu Rhongji – ‘The Shanghai Clique’

Post‐Tiananmen lesson ‐ liberalization must not entail loss of political control

Focus shifted from rural entrepreneurship to state‐ dominated urban economy

• Inflationary surge & subsequent aggressive monetary tightening , rising youth unemployment culminated in Tiananmen –
• Inflationary surge & subsequent aggressive monetary tightening , rising youth unemployment culminated in Tiananmen –

Foreign capital systematically favored over indigenous entrepreneurs 1

1 – Pei (2006)

“Chinese peasants, your name is misery” – Sun Dawu, rural entrepreneur in Hebei province • In

“Chinese peasants, your name is misery” – Sun Dawu, rural entrepreneur in Hebei province

In the ‘90s China embraced state capitalism under Jiang Zeming & Zhu Rhongji

Party superficially embraced some market institutions but increasingly encroached on enterprise and finance through greater centralization and a selective reversal of earlier reforms

Favored urban SOEs and foreign capitalists over indigenous entrepreneurs

Rapid development of coastal enclaves like Shanghai, Dongguan, Shenzen, etc. ‐ active courtship of FDI Restricted access to financing for non‐state business, granted generous subsidies to SOEs

Rural and urban income growth stalled as nominal growth took primacy

Administration/fiscal management of rural localities recentralized, lost fiscal autonomy

Rural tax burden grew significantly, proceeds used to subsidize urban growth

Rural household income grew just 3.8% from ‘89‐’01 – GDP annualized 16.5% same period 1

Govt. bureaucracy ~2x during decade

Govt. payroll up from 20mm in the early ‘90s to 46mm in 2004 2

Significant re‐centralization of finance led by Zhu Rhongji to control mid ‘90s inflation

Private financial institutions banned by 1998, 3, 4 imposed non‐performing loan reduction quotas on banks

Est. Central Finance Work Commission CFWC to regain authority over bank branches from local officials 5

Jiang Zeming subsequently loosened restrictions, resumed de‐centralization in early ’00s

Zhu Rhongji supporter Wang Xuebing’s corruption scandal partially shifted political balance

‘Well‐off society’ growth initiative designed to cement Jiang’s legacy in his final years, required credit growth

  • 1 – Huang (2008), 117

  • 2 – Albert Park & Minggao Shen. “Joint Liability Lending and the Rise and Fall of China’s Township and Village Enterprises.” Department of Economics, University of Michigan (2001)

  • 3 – Shih (2007), 177 34– Shukai Zhao, “Bianju Zhong De Ziangzhen Jigou [Changing Township Organizations],” State Council Investigation and Research Report 168 (2004)

• 4 generation leaders – Hu Jintao & Wen Jiabao – 1 generation to inherit rule

4 th generation leaders – Hu Jintao & Wen Jiabao

 

1 st generation to inherit rule as picked successors

 

Selected and ushered in by “core” leader Jiang Zeming Reflects increasing ‘bureaucratization’ of party

Hu Jintao – President of PRC, Party General Secretary

 

Consensus‐builder, shifted policy priorities from economic growth towards sustainable development and social welfare ‘scientific development’

Policy strives to create a society centered around a prosperous middle class ‘harmonious society’

Rose through China Communist Youth League CCYL and retains significant patronage network of CCYL alumni

Wen Jiabao – Premier of PRC, Secretary of State Council

 

Populist reformer; rose under the patronage of Hu Yaobang, who appointed Wen to the Central Committee/Politburo

Socially moderate, increasingly outspoken progressive

Potentially sympathetic to political reform

• 4 generation leaders – Hu Jintao & Wen Jiabao – 1 generation to inherit rule
• 4 generation leaders – Hu Jintao & Wen Jiabao – 1 generation to inherit rule

社会 ­ Héxié shèhuì “Harmonious society”

Remainder of Standing Committee dominated by former members of Jiang Zemin’s ‘Shanghai clique’

6 incumbents inhibit and complicate reform process

Difficulties intensified by significant expansion of state bureaucracy and patronage networks by extension under Jiang Zeming

Party is increasingly cognizant of potential problems, but remains wedded to statist solutions

18 th 5 Year Plan reflects this approach:

Goal: Rebalance economy on a sustainable footing and reduce rural/urban inequality

Plan: $1.5 trn in infrastructure spending, support the development of specific higher value‐add industries

Unfunded commitment likely to be financed by state banks

Continuing emphasis on state‐led investment and additional hard infrastructure

Responds to symptoms but ignores structural causes

Critical need for ‘soft’ infrastructure – i.e. establishment of rule of law, tolerance of private finance, etc.

Pending transition to 5 th generation at 18 th Party Congress in 2012

Xi Jingping thought to be Hu Jintao’s likely successor

Moderate centrist, strong reputation on corruption

Rose to prominence largely due to success in various roles in Fujian and Zhejiang provinces

Potentially destabilizing political dynamic

No guarantee that current primacy of a balanced Standing Committee will remain under next generation

Possible that People’s Liberation Army PLA will seek representation to reflect its shifting role in the state

• Party is increasingly cognizant of potential problems, but remains wedded to statist solutions – 18
• Party is increasingly cognizant of potential problems, but remains wedded to statist solutions – 18
IV. Industry & the State
IV. Industry & the State

What is the current state of Chinese industry?

China’s privatizations in the ‘90s proceeded according to the blueprint:

‘Let go of the small, take hold of the big’ ‐ 15 th Party Congress, 1997 Dictated by poor performance of state industry

Divested smaller, inefficient SOEs, concentrated on restructured national champions 1 :

Small SOEs – ~20% of sector in ‘97 but comprised majority of operating losses

Small SOEs privatized, laid off 30‐40mm workers to enhance profitability