communism comes of age
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IMPORTANT DISCLAIMER:
THE FOLLOWING PRESENTATION REPRESENTS MY PERSONAL OPINIONS
AND DOES NOT REPRESENT A COMPRHENSIVE ANALYSIS OF THECHINESE ECONOMY. ALTHOUGH THE INFORMATION CONTAINED HASBEEN OBTAINED FROM SOURCES BELIEVED TO BE ACCURATE I CANNOTGUARANTEE ITS ACCURACY, COMPLETENESS, OR FAIRNESS. OPINIONSINVOLVE NUMEROUS ASSUMPTIONS WHICH MAY OR MAY NOT PROVEVALID AND WHICH MAY BE CHANGED WITHOUT NOTICE.
THIS PRESENTATION IS INTENDED FOR INFORMATION PURPOSES ONLYAND DOES NOT CONSTITUE INVESTMENT ADVICE, A RECOMMENDATION,
SOLICITATION, OR OFFER AND IS NOT THE BASIS FOR ANY CONTRACT TOPURCHASE OR SELL ANY SECURITY OR OTHER INSTRUMENT.
I, AS WELL AS PERSONS ASSOCIATED WITH MYSELF, MAY MAINTAIN
POSITIONS IN SECURITIES, INSTRUMENTS, AND/OR MARKETS REFERREDTO BY THIS PRESENTATION.
Questions, comments, and all other inquiries should be directed toshort.china.blog@gmail.com
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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
Ren Xiong (1823-1857)LateQingdynastypainterofthe
Shanghaischool
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I. Macroeconomic Review
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Since reform began in 1978, China hasachieved spectacular growth:
9.8% annual growth since 1978
Worlds 2nd largest economy in 2010 Worlds 18th largest economy in 1978
IMF predicts:
China GDP USA GDP by 2016 PPP
Notable divergence from developedworld in 20082009
Consensus view
Gradualist school
China is incrementally converging withWestern economic and political norms
China will overtake the US as globalconsumer and economic leader
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In billions of USDSource: IMF
GDP
Chinas growth record is impressive, even when compared to otheremerging markets:
0
2000
4000
6000
8000
10000
12000
14000
16000
1980 1985 1990 1995 2000 2005
China
US
Euro Area
Canada
Japan
India
Brazil
Korea
Indonesia
Malaysia
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How has this been achieved so quickly?
Source: IMF
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
Chinas
Share
of
World
GDP
1978-
2010
Howhas
China
gone
from
being
an
economic
backwater
to
threateningAmericansupremacyinjust30years?
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How does China manage this seemingly impossible balance?
Weaddresseachofthesepointsinturnbeforereviewing
Chinasfinancial
and
political
economy:
Maintain weak renminbi RMBto preserve export competitiveness
Restrain inflation
Achieve consistent growth
78% explicit target
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Chinese macroeconomic policy attempts tobalance:
Open capital account
Necessitated by reliance on trade Porous capital controls Open to foreign direct investment (FDI) withlimited portfolio flows
Fixed exchange rateManaged peg to USD
Independentmonetary policy
Theory suggests this is impossible
1,2,3
The Impossible Trinity
This balance has been achieved by the statescoercive power and its dominance of domestic
markets
1 R.A.Mundell,CapitalMobilityandStabilizationPolicyunderFixedandFlexibleExchangeRates,CanadianJournalofEconomics&PoliticalScience29(1963)2 M.J.Fleming,DomesticFinancialPoliciesunderFixedandFloatingExchangeRates,InternationalMonetaryFundStaffPapers 9(1962)3 A.Rose,ExchangeRateVolatility,MonetaryPolicy,andCapitalMobility:EmpiricalEvidenceontheHolyTrinity,NBERWorkingPaper4630(1994)
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Having Your Cake
Exports subsidized by central bank, the Peoples Bank of China (PBOC) Monetary authority, acts in broadly similar fashion to developedmarket central banks
Normally, Chinas persistent trade surplus would cause the renminbi
(RMB) to strengthen against the dollar (USD):
The PBOC prevents the trade balance from adjusting byintervening 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
Inherently inflationary; impact must be compensated for
Impact sterilized by removing currency from circulation
9705 China formally peggedRMB against USD
0508 Managed float allowsfor ~20% appreciation
08 Present Defacto USD peg@ ~6.80 RMB/USD globalslowdown calls for halt to
appreciation
A Brief History ofChinese Currency
Manipulation
1 J.Greenwood.TheCostsandImplicationsofPBOCSterilization,CatoJournalVol.28,No.2(2008)
Sterilization causes significant local andinternational economic distortions
Sterilization
can
only
postpone
inevitable
adjustments
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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
Newlyprinted 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 RMBcreation through fractional reserve banking
A Brief History of ChineseCurrency Manipulation
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Free from the rule of law, China has used financialrepression to limit the inflationary impact ofperpetual money printing:
PBOC sets deposit and lending rates artificially
PBOC imposes lending quotas on banks
PBOC issues ST notes and Special Bills to banks
Low yielding bonds forced upon banks to immobilizebank assets below market coupons De facto increase of bank reserve requirements 5.1% of domestic assets at 12/31/101
Bank reserve requirements 23.5% of domestic assets at 12/31/102
~30%ofbankcapitalimmobilized
Inflationary pressures continue nonetheless
1,2 PBOC 2010AnnualReport,ChinaBankingRegulatoryCommission
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Chinahasmadecappingpricerisesthepriorityofmacro-economicregulationandintroducedahostof
targetedpolicies.
These
have
worked.
We
are
confident
price
rises
will
be
firmly
under
control
this
year.
Wen Jiabao (), 6/23/11 Financial Times editorial
Official figures understate true market rates anecdotal evidence of rates in shadow bankingsystem >20% in 2011
Source: PBOC, Bloomberg, China Economic Information Network
-15%
-10%
-5%
0%
5%
10%
15%
20%
1/1/2007 1/1/2008 1/1/2009 1/1/2010 1/1/2011
SHIBOR 3Mo.
DepositRate 3 Mo.
CPI, YoY
PPI, YoY
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0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
0.0
2,000.0
4,000.0
6,000.0
8,000.0
10,000.0
12,000.0
14,000.0
US M2
China M2,USD
US YoY
China YoY
US & Chinese Monetary Aggregates
A sight to humble even Helicopter Ben
Source: Federal Reserve, PBOC
Massivefiscalstimulus 14%ofGDP!(USstimulus 6%)
The PBOCs perpetual money printing calls into question demandbased estimates of the value
of Chinese currency Chinahas
agreater
money
stock
than
the
US
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Explicit costs of sterilization:
Spread between costs of special bills and return onforeign assets Size of special bills relative to size of foreign assets
1 PBOCStatistics&Figures2010
Implicit costs of sterilization: Lending shifts to shadow banking system
Off balance sheet leverage andunderground banking system
Distorts capital allocation PBOC balance sheet expansion crowds outconsumption
Balance sheet must grow with economy tomaintain peg 12/31/10 PBOC is levered 1,180x!1
Inflation can only be suppressed temporarily:
Liquidity overhang remains on PBOCbalance sheet Significant obstacle to deploying reservesdomestically
Ultimate adjustment filters through via: Domestic prices
Export sector via resource procurement Significant buyer of commodities
0
500
1,000
1,500
2,000
2,500
3,000
3,500
12/1/1999 12/1/2001 12/1/2003 12/1/2005 12/1/2007 12/1/2009
Billions of USDSource: China Economic Information Network, Bloomberg
ForeignExchangeReserves 1999-2011
CurrentPBOCGovernorZhouXiaochuan ()
At 6/31/11 Chinas reserves were:3.4x 2005reserves
17.7x 2001reserves
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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
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
HouseholdSavingsDeposits 1Yr. Rate
China 1 Yr.LendingRate
DepositReserveRatio
1 Christer Ljungwall,Christer,YiXiong,andZou Yutong. CentralBankFinancialStrengthandtheCostofSterilizationinChina. CERCWorkingPaper8(2009)
Source: PBOC, Bloomberg
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Mercantilist trade policy/sterilization has led China to share Japans burden ofunderwriting American profligacy China is a forced buyer:
Source: US Treasury, billions of USD
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
45.0%
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
US Debt, Held byForeigners
US Debt to China
US Debt toJapan
China, % of Tot.
Japan, % of Tot.
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China is ~10% of World GDP but its share of global commodity consumption ismuch higher:
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
Cement Iron Ore Coal Steel Lead Zinc Alumninum Copper Nickel Pork Eggs Rice Soybeans
Source: GMO, 4/11 Quarterly Letter
Chinas resourceintensive growth is stretching global supplyFurther growth will prove increasingly costly and pressure domestic prices
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-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
1978 1981 1984 1987 1990 1993 1996
CPI, YoY
CPI, Urban, YoY
CPI, Rural, YoY
Previous inflationary surges (late 80s, mid 90s) managed by extraordinary financialrepression
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
Source: PBOC, Bloomberg
ChineseConsumerPriceIndices 1978-1998
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Like Asian peers, China has utilized the exportgrowth model:
Arbitrage advantage from low cost labor
2035%/GDP from exports
Ultimate impact is larger:
Proceeds are levered through statefinancial system & reinvesteddomestically
4050% of GDP from fixed assetinvestment
Primary destinations for fixed assetinvestment1:
Export production capacity
Real estate
Significant leverage to global demand
Investment increasingly compensating for weakglobal demand:
~70% of 2008 growth
~90% of 2009 growth2
1 MoodysAnalyticsReportChina:FixedAssetInvestment. Published6/13/2011.
2 PivotCapitalManagementReport ChinasInvestmentBoom:TheGreatLeapintotheUnknown(2011),NationalBureauofStatistics
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Exports & Gross Capital Formation / GDP 1981 2009
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
1981 1986 1991 1996 2001 2006
Gross Cap.Form. (FixedAssetInvestment)
Exports
Combined
Globaldownturnliterallypavedover:
Source: World Bank
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1 HSBCGlobalResearchCurrencyWeekly,06/07/2010, p.5
2 PivotCapitalManagementReport ChinasInvestmentBoom:TheGreatLeapintotheUnknown(2011),p.7. Chartsexcerptedfromsamereport.
Real estate is another significant destination for fixed asset investment:
HSBC estimates total value of residential property at 3.27x GDP1
Almost2xlevelinUSbeforesubprimecrisis ClosetoJapanesepeaklevelof3.8x
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 1520x in major cities, ~10x in regional cities2
9x in London, 12x in Los Angeles in 2007
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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 tops1:
PingAnInsurancesnewShenzen
headquarters 115floors,648m under
construction
Goldin Finance117,Tianjin 117
floors,597m underconstruction.
Masterplanalsocallsfor270story
towersand
residential
high
-rises
1 AndrewLawrence, TheSkyscraperIndex:FaultyTowers,PropertyReportDresdnerKleinwortWassersteinResearch (1999)
TheGuangzhouUrbanPlanningBureaus
proposedcenterpiecefortheplannedBaietan
CBD 118floors,650+m. Thedistrictwill
havemore
than
10mm
sq.
meters
of
floor
space.
ForthebenefitofAmericanreaders,Chicagos Willis(Sears)Towerisonly527mwhenits85mantennaeareincluded
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Dubai X 1000?
Tianjin is planning an especially grandiose central business district which is currentlyunder construction:
Construction of Phase 1 of project is underway The towering building visible at center left is to be ~600m,which would be the worlds second tallest if it stood today
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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
Macroeconomic 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
1 BarryEichengreen,Donghyun Park,&Kwanho Shin.WhenFastGrowingEconomiesSlowDown:InternationalEvidenceandImplications forChina,
NBERWorkingPaper16919(2011)4
Experience of other Asian tigers suggests growth will slow irrespective of internal obstacles1
Middle Income Trap export model has limitations Export & invest model precludes balanced growth & formation of consumer society
TemptingcomparisonstoJapanbutrealities
ofChinaareevenstarker
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Consensus: China will rebalance and replace US as globalconsumer 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 become a consumer nation withoutsignificant 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 bycaptive capital of private savers
Nonstate 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 foreigninvestors and stateowned enterprise
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Populace has not shared in gains from growth:
Personal income/ capita severely lags GDP/Capitagrowth, which itself lags GDP growth1
Wage squeeze worsened by inflation/asset bubbles
2nd largest economy, but 93rd in GDP/Capita IMF Between Macedonia (92nd) & Algeria (94th)
GDP/Capita overstates income as only ~40% flowsthrough to labor
Labors slice of the pie is shrinking2:
1997 Wages/GDP: 53% 2007 Wages/GDP: 40%
Large wealth inequality
0.4% of Chinese control 4050% of wealth3
Gini coefficient: 47 in 2010 according to state ests.4
Understated, excludes hidden income
Concentration of wealth reflects concentration ofpower amongst political elites
How successful can the Chinese miracle be when
so few have enjoyed its benefits? Source:WorldBankDevelopmentIndicators,19752008.
$0.00
$2.00
$4.00
$6.00
$8.00
$10.00
$12.00
$14.00
$16.00
S. Korea Singapore Brazil Hong Kong Mexico China
2008Avg.HourlyWage
1 A.R.KhanandCarlRiskin,IncomeandInequalityinChina:Composition,DistributionandGrowthofHouseholdIncome,1988to1995,TheChinaQuarterly154(1998)2 RichardMcGregor,TheParty(NewYork:HarperMacMillan) 20103 VictorShih,HighWealthConcentration,PorousExchangeControl,andShockstoRelativeReturn:TheFragileStateofChinasForeignExchangeReserve,PresentationattheInstituteofNewEconomicThinking,Bretton Woods,NH(2011)4 ChenJia,CountrysWealthDividePastWarningLevel,ChinaDaily,05/12/10. Accessed08/23/11.http://www.chinadaily.com.cn/china/2010 05/12/content_9837073.htm
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Since the early 90s, Chinas urban populace has been favored at theexpense of their poorer, less educated rural compatriots:
Per capita income1:
Urban $2,000
Rural $ 605
Limited job opps. 40% of rural population un or underemployed2
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) rural/urban class register system exacerbates divide:
Rural citizens literally second class citizens with restricted mobility Creates marginalized class of 150mm migrant rural laborers3
Rural workers can move to cities to seek jobs, but lack access to basicpublic services due to rural citizenship
Often forced to work in informal lowpaying jobs
Social position analogous to illegal immigrants in the US
1 Yasheng Huang,CapitalismwithChineseCharacteristics:EntrepreneurshipandtheState (NewYork:CambridgeUniversityPress,2008)251.2 JasonGale&BretOkeson.ChinaDoctorsEarning$300aMonthFlocktoDrugCompanies, BloombergBusinessweek,7/10/11.3 JohnBryanStarr,UnderstandingChina:AGuidetoChinasEconomy,History,andPoliticalCulture,3rdEdition(NewYork:Hill&Wang,2010)162.4 Ibid,pp.148149.
Privatizations of 90s dismantled Iron Rice Bowl )social security net: SOEs used privatizations to jettison lowproductivity workers at firms thought to be ~30% overstaffed4
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 jobless4
Current government retirement programs available only to urban residents, ~95% funded by local governments 4
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Local governments now responsible for education,healthcare, and social security after late 80s reforms:
Created problematic conflicts for local leaders withsignificant social consequences:
New responsibilities were unfunded mandates Local officials performance still assessed by nominal growth: Incentivized to favor short term economic growth over longterm
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 yearend 2009!1
Incentive structure promotes short termism in local finance
Sales of expropriated prop. frequently used to fund budget gaps
Arbitrary seizures of peasant farmland, property resold 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 governmentsword is law: Seeking justice higher up the state hierarchy difficult and dangerous
1% of petitions for redress to government resolved satisfactorily3
1 AnthonyChanChinasHiddenDomesticPublicDebt:SomePerspectiveontheRisksitPoses,AllianceBernstein GlobalEconomicResearchReport(2010)2 Starr,176.
3 Ibid,84
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Healthcare 2000 World Health Organization study ranked Chinas
healthcare system 144th globally1
Behind Burundi 143rd, ahead of Mongolia 145th
~40% of sick rural residents did not seek medical care due to
its unaffordability2
~60% of rural residents requiring hospitalization did not seektreatment due to unaffordability2
1 public health professional / 7,000 people US 1/6353
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 90s4
Inequality continues to rise:5
Lack of training drives inequality in wages6
Illiteracy increased 64.3% between 2000 and 2005
Equivalent to 30% of rural school cohorts from 1990s7
Rural secondary school dropout rates 43% in 00038
1 WorldHealthOrganization. WorldHealthReport2000.2 Yasheng Huang,CapitalismwithChineseCharacteristics:EntrepreneurshipandtheState (NewYork:CambridgeUniversityPress,2008)251.3 JasonGale&BretOkeson.ChinaDoctorsEarning$300aMonthFlocktoDrugCompanies, BloombergBusinessweek,7/10/11.4 Carsten Holz,ChinasEconomicGrowth19782025:WhatWeKnowTodayAboutChinasEconomicGrowthTomorrowHongKongUniversityofScience &Technology,2005.
5 RaviKanbur &Xiaobo Zhang, FiftyYearsofRegionalInequalityinChina:AJourneythroughCentralPlanning,Reform,andOpenness,ReviewofDevelopmentalEconomics 9(2005)6 Z.Liu,TheEffectsofEconomicReformsonWageInequality:SomeEvidence fromChina,AppliedEconomicsLetters,8,(2001)7 Huang,43
8 Ibid,248
Patientsawaitingtreatment
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II. Banking & Finance
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Chinese finance speaks to the fundamentally poorprospects for structural transition without reform:
Chinas 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
Banking sector provides cheap capital for SOEs, local govts.
State sets interest rates and limits investmentoptions for savers
Fixed deposit rates, fixed lending rates
Creates cheap, captive capital for state banks
Real deposit rates frequently negative
De facto
Alternatives for savers restricted to stocks, RE
Encourages speculation, distorts asset prices Shifts investment to unregulated shadow
banking system
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0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
1982 1987 1992 1997 2002 2007
FDI, % ofGDP
Grosssavings, %of GDP
Source: PBOC, Bloomberg
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1 Walter&Howie,44;YangKaisheng,SeveralThoughtsaboutStabilizingtheCapitalAdequacyofourCommercial Banks,21st CenturyBusinessHerald,04/13/2010
Inourcountryscurrentlevelof
macroeconomicdevelopment,wemust
maintainalevelofmacroeconomic
growthof
around
8%
per
annum
and
thiswillinevitablyrequirea
correspondinglevelofcapital
investment.
Ourcountrys
financial
systemisprimarilycharacterizedby
indirectfinancing(viabanks);the
scaleofdirectfinancing(viacapital
markets)is
limited.
YangKaisheng (),CEOof
Industrial&CommercialBankofChina1
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1 Saez,Lawrence,BankingReforminChinaandIndia, (NewYork:PalgraveMacmillan, 2004)
2 CarlWalter&FrasierHowie, RedCapitalism:TheFragileFinancialFoundationofChinasExtraordinaryRise, (NewYork:JohnWiley&Sons,2011)
CapitalRaising
Activity
1993
-2009
Source: PBOC Financial Stability Report 2010
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Bonds
Bank Loans
Equity
The subsidized domestic banking system finances almost all economic activity1:
Bank loans & bonds account for 1
Equity financing immaterial Foreign banks 2% of financial assets2
Keeps capital market exposure to a minimum
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1 Walter&Howie,86.
Chinas reliance on its state banking systemis understated as corporate bonds are
:
70% held to maturity by state banks1
22 of 24 primary dealers are state banks1 Underwriting bond and retainingcredit risk effectively a loan
The Chinese yield curve is a construction ofthe state:
Uses stateset bank 1 year depositrate as abaseline Trading volume is insignificant yield curvecan be drawn arbitrarily
Bonds issued and sold primarily to governmentcontrolled entities:
Sold at below market coupons Selling unattractive for holders
Creates losses due to belowmarket issuance; politically unappealing
Illustrative of Partys superficial adoption of market institutions:
Structure adopted to maximize partys ability to limit the impact of market forces Institutional character informed by earlier experiences with retail bond market
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The banking system is Chinas de facto second treasury:
Capital allocation system fundamentally since 70s
Party views banking system as policy tool and as a vehicle forpersonal enrichment
o Capital is often politically directed and used by localofficials to accomplish the partys economic targets
o
Senior bank officials & SOE managers selected bynomenklaturasystem
o Party retains majority equity ownership & ultimatecontrol
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1 Bankannualreports,various,PBOC AnnualSurvey&Statistics2010.
Corporate banking in China is dominated by 4 large
statecontrolled banks The Big 4 and their emergingrival BoCom:
Primary tools of state in managing the economy: A second treasury
Despite purported commercialization and publiclistings govt. influence remains significant Credit frequently extended on the basis of personalrelationships rather than perceived creditworthiness
Listed with share of domestic financial assets as of 12/31/101
:
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 6.4% Emerging rival to Big 4
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
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1 BankAnnualReports,PBOC.
The core of the banking system is rounded out by theexplicitly statist policy banks:
Listed with share of domestic financial assets as of 12/31/101:
China Development Bank CDB 8.3% Agricultural Development Bank of China ADB 2.8% China ImportExport BankCIE 1.4% China Postal Savings Bank CPSB Undisclosed
Formed in 1994 to take over policy loans from newlycommercialized Big 4 as part of larger fin. sector restructuring
Despite stated mission, majority of activity is indistinguishablefrom operations of commercialized Big 4
ChinaDevelopmentBank(CDB)
Particularly important in recent years:
Led by Revolutionary princeling son ofChinas former supreme state planner , Chen Yun
Lendingvol.onparwithMinistryofFinance 12/31/2010loanbook2XWorldBanks
Sovereign wealth fund, but majority ofinvestment is domestic
70% funded by commercial banks (Big 4)
Shift to universal bank strategy has led statecompetitors to similarly diversify business lines
Introduced new securitized productsExemplifies expansion and ambition of statecontrolled financials
Financier of state ego projects Three Gorges Dam, Shanghai Pudong Aiport,Beijing Olympic projects, etc.
Policy Banks ex. CPSB
Big 4 BOCOM Policy Banks ex. CPSB
Concentration has increased in past decade Centralization of finance aids and abets party control
Ifitdoesnthaveaccesstoastableandsufficientsourceofcapital,theChinaDevelopmentBankwillbe
unableto
operate
normally
Anonymous, Treasury Department, CDB. Quoted 01/11/10 in TheEconomicObserver()
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5- Year Asset CAGR ROARE Loans /Total Loans
OBSCommitments/ Total Loans
NPLRatio
Tier 1Capital
CommercialB
anks 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 & CommercialBank of China 15.8% 1.3% 27.0% 54.3% 1.2% 9.7%
PolicyBanks China Development Bank 21.9% 0.8% N/A N/A 0.6% N/A
Agricultural DevelopmentBank 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 asof 12/31/10
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With aggressive loan growth and weak cash flow generation, Chinese banking isunusually capital intense and requires constant refreshment.
And yet, >50% of 0510 & 95% of 0710 new equity capital paid in dividends!This oddity is more explicable when we recall that vast majority of bank dividends accrue tothe state
(300,000)
(200,000)
(100,000)
0
100,000
200,000
300,000
400,000
2005 2006 2007 2008 2009 2010
Proceeds fromSale of CommonStock
Dividends Paid
Source: Bloomberg, Bank annual reports
EquityOfferings&DividendPayouts,Big4Banks,2005-2010
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0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
Dec-99 Nov-00 Nov-01 Nov-02 Nov-03 Nov-04 Nov-05 Nov-06 Nov-07 Nov-08 Nov-09 Nov-10
Domestic Credit
GDP
Source: PBOC, Bloomberg, billions of RMB
Creditis
growing
faster
than
GDP
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0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10
Total Loans ofFin. Institutions,YoY (L. Axis)
NPL Ratio (R.Axis)
Loan growth has slowed but remains dangerously high
Source: PBOC, Bloomberg
NPLs appear minimal but are a backwardlooking indicator in a loose credit environment
Stimuluswall:
banks
given
green
light
for
growth:
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Chinas state financial system has historically fared poorly &has an unfortunate track record1:
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 impactof new wave of bad loans 40% of pre2000 loans bad!2
Govt. response led to current market structure
Historical recoveryratesinthe10-20%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 andtheft 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 smallinfusions of forex reserves and capital raised from IPOs Perceived success of bank recaps. and subsequent collapse of Westernfinancial system has reduced perceived need for reform
1 VictorShih,Factions&FinanceinChina:EliteConflictandInflation,(NewYork:CambridgeUniversityPress,2007
2 Walter&Howie
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1 ThomasBottini,BankruptcyPerilsinChina:TheGITICTale,MultinationalBusinessReview115(2003)
GITIC Forerunner of todays banking sector? Engaged in practices common in modern Chinese finance i.e. off balancesheet vehicles, growth of noncore 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 GITICs international deals
Explicit assurance that state stood behind the bank Enormous expansion in 90s aided by Western banks
One of Chinas first international players
Went bust in wake of Asian financial crisis January 1999 NPL ratio: 1
Recovery rate: 1
First and only bankruptcy of major Chinese financial:
Assets: $2.6 bn Claims: $5.6 bn $4.7 bn to foreign creditors
International exposure prompted larger concern regarding Chinas solvency Necessitated immediate action and a transparent liquidation process:
Appointed KPMG to build credibility with westerners
GITICSformerheadquarters;3rd tallest
buildinginAsiaattimeofconstruction
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1 Walter&Howie
2 Bottini
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 easilysettle the bill PBOC put reflected in bond risk:
8 mos. before collapse, GITIC bonds yielded just 240 bps over Treasuries1
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. and uncovered
Scale of debts led to closures of many trust companies and recentralization of Big 4 under
central governments control
PostGITIC reforms sought to recentralize control over the financial system Not about enhancing capital allocation No intention of allowing truly private banking or floating interest rates
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While the provincial GITIC was allowed tofail, China pursued more innovativesolutions to resolving the banks under thedirect control of the central government in
the late 90s / early 00s
Particularly important to the recapitalizationand underpinning Chinas financial systemare the 4 asset management cos. AMCs:
Chinas4AMCs:Orient,Huarong,GreatWall,andCinda
Bad banks used to remove problem loans from bank balance sheets Created to deal with primarily vintage NPLs that remained from past crises:
Govt. delayed resolution until exogenous shock of AFC demanded action 40% of pre2000 loans nonperforming1
AMCs acquired RMB 2.4trn of bad loans to recapitalize financial system
AMCs funded by PBOC AMCs purchase NPLs at face value 100s 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 into banks Accounting solution; to bad loans
1 Walter&Howie
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Intended as temporary institutions, theAMCs 1999 mandate was renewed in 2009for a further 10 years:
Thinly capitalized; inevitably insolvent Negligible capital base and inflated purchase
price of loans made profitable operationimpossible from the beginning Significant operating expenses exacerbateddearth of loan recoveries ~11% by 051,2
Government has had to provide comfortletters to auditors to assure solvency
More recently the elegant AMC system hasbeen abandoned in favor of direct issuance ofunfunded receivables by the Ministry ofFinance MOF:
Mechanics remain the same; banks receiveunfunded, evergreen IOUs
AMC bonds and subsequent MOF receivables aresignificant state liabilities
figures
1 Shih(2007),174
2 Neina Wang,Thetotalassetsandliabilitiesinthebankingsectorgrowbyapproximately19%Zhongguo Zhengquan Bao (ChinaSecuritiesNews),10/12/05
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AMCs like Cinda haveopportunistically used thelicenses of their seized portfoliocompanies to enter a wide
variety of business lines,significantly expanding beyondtheir original mandate:
Seized operating businesses
continue as going concerns
Employ 12,000 people
Bad banks now diversifiedconglomerates
Operating losses worsen alreadyweak financial position
Cindas subsidiaries span life insurance, P&Cinsurance, securities brokerage, equipment finance,futures trading, investment management, real estateinvestment, trust management, propertydevelopment, construction, and even includeindustrial businesses.
AselectionofsomeofCindas publicallyacknowledgedsubsidiaries
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AMC bonds and later MOFreceivables comprise asignificantportion of theBig 4s capital base:
Big 4 Banks - Big Balance Sheet Holesin 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.
Bonds rolled with AMC mandate
Evergreen NPLs: Oldest underlying loans reportedlydate to late 80s and early 90s Continued presence on bankbalance sheets speaks to kick thecan approach to restructuring
Banking system rests on shakyfoundation of accounting trickery
Investors aware of potential balancesheet holes but believe in PBOC/MOF put
Assumption that state will be ableto replicate GITIC restructuring
Confidenceinthebankingsystemreflectsinvestorconfidenceintheabilityof
thestate
to
recapitalize
financial
system
large
forex reserves
provide
illusory
comfort
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th
The PBOC even has its own bad bank used to hide debts & disguise its probable insolvency:
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 1st
generation AMCs
Official documents suggested Huida was to acquire real estate loans fromHainan/Guangxi and portfolios from the GITIC bankruptcy midlate 90s vintages:
Belief among market participants is that Huida instead acquired the PBOCs original AMC loans
in order to ease pressure on insolvent AMCs1
This would imply a roundtrip investment that would offset and disappear if the entities wereconsolidated
Unaudited, off balance sheet vehicle for PBOC and Cinda
Unlisted and unmentioned on Cindas website; fiscal black hole1
1 Walter&Howie
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State Council
Ministryof
Finance
PBOC
Financial RegulatorySoup (NDRC, CBRC,CSRC, CIRC)
StateOwned AssetsSupervision & Administration
Commission(SASAC)
SOEs
China InvestmentCorp. (CIC)
Central HuijinInvestment
Central SAFEInvestment
Asset ManagementCos. (Huarong, Orient,
Great Wall, Cinda, Huida)
Big 4 and ChinaDevelopment Bank
The Ministry of Finance, operating directly under the State Council, lies at the heart of the contemporary Chinesefinancial 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 party1: MOF dominated by generalists: Typically rotated between ministries and localities
Historically has favored decentralization 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
1 Shih(2007)4763
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The current ownership & regulatory structure of Chinas financial systemis the product of stillborn 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 beforethe PBOCs reforms could be completed
MOFs political ascendancy strongly reduced the likelihood of further reform
Regulatory reform has been hampered byinternal conflicts between the treasuryMOF and the central bank PBOC
This conflict is reflected in the countrys duelingsovereign wealth funds SWFs:
China Investment Corporation CIC
Central SAFE Investment SAFEThenondescriptentrancetoMOFheadquartersinBeijing
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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 stemmingfrom the PBOCs 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 balanceof 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 PBOCs existing sovereign wealth fund: MOF had blamed PBOC for rising inflation, accused it of poor management of reserves3
1,2 Walter&Howie,1718
3 Ibid,131
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It is through CIC that the MOF hasenforced its dominance over the PBOCand taken control of the state banks1:
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 pluggedby accounting gimmicks i.e. AMC bonds Former controlling shareholder of Big 4,
majority representation on boards of Big 4/CDBvia Huijin Investment Huijin
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
1 Walter&Howie,127138
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III. Party & State
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The party not only retains significant influence in allocating capital but continues todominate industry by favoring stateowned 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 centralplanning apparatus
Reality: Many structural reforms have largely been reversed postTiananmen
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 thecurrent and future direction of reform:
We
briefly
review
the
structure
of
the
Chinese
government
before
summarizingthedecadessincereform:
Thelast
thirty
years
have
been
great
on
one
level.
The
economy
has
advanced,
but
culture,
society,andpoliticshavenot. Inessence,itisthesameoldsystem.
Wang Xiaofang, former party bureaucrat1
1 Hongru Liu, TheFormationof theThinkingandReformProposalsforChinasFinancialSystemReforms,2000.
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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 roles withingovernment and party:
e.g. Hu Jintao is both General Secretary of the Communist Party ofChina and President of the Peoples Republic of China
Party retains power of appointment while party agencies i.e. Central
Organization Dept. et. al. monitor performance of appointed officials
TheHammer&SickleoftheParty
Party led by 25person Nominally appointed by Party Central Committee but selfperpetuating in practice Agenda dictated by General Secretary, decisions achieved by consensus Meets monthly
The Politburo is in turn dominated by the of the Politburo: Consists of 9 most powerful members of Politburo Chinas board of directors
Members represent all major policy areas The contemporary standing committee is increasingly structured to check the excesses ofindividual 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
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Unrestricted by the rule of law, Chinesegovernment is inefficient and inequitable:
Chinas constitution is a mission statementrather than a legal document1:
4 versions since 49, most recent version adopted~30 years ago and modified 4 times subsequently
Unpredictable policy environment with frequentlychanging rules & degrees of enforcement
Without checks and balances & effectiveenforcement mechanisms, policy making &implementation are frequently
Regulatory structures often reflect internecinepolitical conflicts i.e. MOF vs. PBOC
1 Starr,60
2 Starr,64
3 WangJingqiong.BeijingtoCloseThousandsofLiaisonOffices.ChinaDaily,01/25/2011.
Petitionerspleadforrelieffromthecorruptionoflocalofficials
Chinas government is 2
The government relies on negotiated relationships between a large number of individualpoliticians, agencies, and organizations:
Particularly marked in relationship between central and local governments Policy is adhoc 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. localgovernment lobbies in Beijing A Chinese K Street1
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 ofproblematic officials via Central Committee for Discipline Inspection
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Nominally 3 branches of government:
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 StateSecurity, etc.
State ministries thought to employ 10mm bureaucrats
Complicated management structure local bureaus report to localgovts. as well as to ministry/commission senior office
Further hinders efficient regulation/administration/
enforcement of localities by the center
Supreme Peoples Court No real independent power exists solely to apply party policy
to specific cases/incidents
National Peoples Congress Historically a rubber stamp legislature, conceived of primarily
as an arena where regional delegates could come to learn andunderstand the mass/party line
Delegates now acting with increasing independence i.e. abstainingfrom votes/voting in dissent, but still without any realindependent legislative authority
Theviewfromthetop
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In the absence of a strong federal government, the edicts of the StateCouncil & the larger party superstructure filter through the largelyindependent hierarchy of local governments:
Political capital of local officials determines relative independence fromcenter 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
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 20111, 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
ShanghaiMunicipalGovernmentBuilding
PeoplesGrandHallinChongqing,seatofthelocal
municipalgovernment
1 FitchWarnds OverChinaLocalGovernmentDebtBBCNews,09/08/11. Accessed 09/27/11.http://www.bbc.co.uk/news/business148363862 YinNongzhing,DeputyDirectorofFinanceCommittee,NationalPeoplesCongressstatedthatRMB10trn wasaconservativeestimateoflocalgovernmentdebt. QuotedininterviewwithReuters,02/02/11. Accessed8/23/11.
http://www.reuters.com/video/2011/02/02/china facingahiddendebtcrisis?videoId=183875158
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Dire need for reform in aftermath of Cultural Revolution Economy in tatters, partys credibility shot after bloodbath led by Red Guards
China came closest to achieving legitimate marketorientedreform 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 1980s1
Mandatory retirement of officials, reform of Party Congress, legal reforms, etc.
Efforts to increase administrative autonomy of local governments
Allowed & 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 Areas most affected by Great Leap / Cultural Revolution led reform
Driven by pragmatic local officials who frequently were actingindependently of the center, particularly in the poorest provinces
Cities remained dominated by SOEs and central planners
1Minxin Pei,ChinasTrappedTransition:TheLimitsofDevelopmentalAutocracy, (Boston:HarvardUniversityPress,2006)11.
Zhao(top)&Hu
Architectsofreform
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TVEs led rural growth spurt :
Led by private entrepreneurs, who were given significantfrom 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 TVEs
were owned & controlled: Output, profit, and wages of private TVEs 5070% higher than statemanaged TVEs1
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 78882
1 Qisong Lin,PrivateEnterprises:TheirEmergence,RapidGrowth,andProblems,InChinasRuralIndustry,editedbyWilliamA.Byrd.(Oxford:OxfordUniversityPress,1990)181.2 Huang117.
Nian Guangjiu founded
IdiotsSeedssunflower
seedsin1982andisrepresentativeofthe
dynamicentrepreneurial
classthatemergedasthe
statelooseneditsgrip.
Nian was
one
of
the
greatestTVEsuccess
storiesofthereformera,
earninga1mmRMB
profitin1986. Inthe90s
hewasjailedwhilehis
businesswasseizedand
subsequentlyrun
into
the
groundbytheprovincial
government.
A Brilliant Idiot:
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Inflationary surge & subsequent aggressivemonetary tightening , rising youth unemploymentculminated 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 tomany 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
PostTiananmen lesson liberalization must not entailloss of political control
Focus shifted from rural entrepreneurship to statedominated urban economy
Foreign capital systematically favored over indigenousentrepreneurs1
1 Pei(2006)
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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 nonstate 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 8901 GDP annualized 16.5% same period1
Govt. bureaucracy ~2x during decade Govt. payroll up from 20mm in the early 90s to 46mm in 20042
Significant recentralization of finance led by Zhu Rhongji to control mid 90s inflation Private financial institutions banned by 1998,3, 4 imposed nonperforming loan reduction quotas on banks
Est. Central Finance Work Commission CFWC to regain authority over bank branches from local officials5
Jiang Zeming subsequently loosened restrictions, resumed decentralization in early 00s Zhu Rhongji supporter Wang Xuebings corruption scandal partially shifted political balance
Welloff society growth initiative designed to cement Jiangs legacy in his final years, required credit growth
1 Huang(2008),117
2 AlbertPark&Minggao Shen.JointLiabilityLendingandtheRiseandFallofChinasTownshipandVillageEnterprises. DepartmentofEconomics,UniversityofMichigan(2001)
3 Shih(2007),177
34 Shukai Zhao,Bianju Zhong DeZiangzhen Jigou [ChangingTownshipOrganizations],StateCouncilInvestigationandResearchReport168(2004)5 Shih(2007),169
Chinese peasants, your name is misery Sun Dawu, rural entrepreneur in Hebei province
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4th generation leaders Hu Jintao & Wen Jiabao
1stgeneration 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 Consensusbuilder, shifted policy priorities from economic growth
towards sustainable development and social welfare scientificdevelopment
Policy strives to create a society centered around a prosperous middleclass harmonious society
Rose through China Communist Youth League CCYL and retainssignificant patronage network of CCYL alumni
Wen Jiabao Premier of PRC, Secretary of State Council
Populist reformer; rose under the patronage of Hu Yaobang, whoappointed Wen to the Central Committee/Politburo
Socially moderate, increasingly outspoken progressive Potentially sympathetic to political reform
Remainder of Standing Committee dominated by formermembers of Jiang Zemins 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
- Hxi shhu
Harmonioussociety
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Party is increasingly cognizant of potential problems,
but remains wedded to statist solutions 18th 5 Year Plan reflects this approach:
Goal: Rebalance economy on a sustainable footing andreduce rural/urban inequality
Plan: $1.5 trn in infrastructure spending, support thedevelopment of specific higher valueadd industries
Unfunded commitment likely to be financed by state banks
Continuing emphasis on stateled investment andadditional hard infrastructure
Responds to symptoms but ignores structural causes
Critical need for soft infrastructure i.e. establishment ofrule of law, tolerance of private finance, etc.
Pending transition to 5th generation at 18th Party Congressin 2012
Xi Jingping thought to be Hu Jintaos likely successor Moderate centrist, strong reputation on corruption
Rose to prominence largely due to success in various roles inFujian and Zhejiang provinces
Potentially destabilizing political dynamic
No guarantee that current primacy of a balanced StandingCommittee will remain under next generation
Possible that Peoples Liberation Army PLA will seek
representation to reflect its shifting role in the state
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Chinas privatizations in the 90s proceeded according to the blueprint: Let go of the small, take hold of the big 15th Party Congress, 1997
Dictated by poor performance of state industry
Divested smaller, inefficient SOEs, concentrated on restructured national champions1: Small SOEs ~20% of sector in 97 but comprised majority of operating losses
Small SOEs privatized, laid off 3040mm workers to enhance profitability
Surviving SOEs given tax and debt relief, import licenses, access to domestic and foreign listingfacilities, and reduced operating restrictions
Policy of 2 Guarantees2
Guaranteed access to financing and raw materials for 234 SOEs
Strongly limited need to remain competitive
Restructuring used to and of remaining SOEs Party retains equity ownership, control via corporate boards and personnel appointments
Significant social welfare consequences
1,2 Huang(2008)
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Private sector significantly smaller than headline figures would suggest: Official definitions are problematic:
Nonstate includes many collective enterprises controlled by local governments
Majority of listed SOEs are classified as nonpublic:
However, state retains and control of corporate boards
2005 OECD study suggests private sector is ~70% of economy1
Confusion regarding legalperson shareholding firms ~40% of private sector
OECD views as private, but majority of legalperson firms are owned by state and directly
supervised by state council: OECD list includes subs. of recognized SOEs like PetroChina and China National Petroleum
Corporation as well as state champions like SAIC Motor
75% have zero individual share capital, 45% are merely production subsidiaries of otherSOEs2
Correcting for this, true private sector is 2
Even if we accept the 70% number at face value, share is still low:
Comparable to Indira Ghandis India with nationalized banking system and the license raj
Private sector primarily concentrated in capital extensive service sector
Reflects restricted access to official sources of financing
1 SeanDougherty&RichardHerd,FastFallingBarriers&GrowingConcentration:TheEmergenceofaPrivateEconomyinChina, OECDEconomicsDepartmentWorkingPapers 471(2005)2 Huang(2008)
3 Ibid,p.124
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Majority of listed cos. are stateowned: Only 7% of 19902003 listings from private cos.1
State sector given preferential access to capital markets Most competitive of truly private companies remain private, HKdomiciled
Many of these national champions did not exist before their public listings Western investment bankers facilitated creation of national champions as part of
restructuring/consolidation of SOEs during late 90s2
Exemplifies partys opportunistic use of market institutions to achieve policy goals
China Mobile particularly egregious example3: Created by rolling up assortment of poorly managed provincial telcos. after 1997 IPO
Proceeds from NYSE listing supplemented with bank loans, used to purchase telcos. in6 provinces owned by its own parent
Prospectus referred to a proforma entity not yet operationally integrated Followed by secondary offering in 2000, proceeds similarly used to expand in a
further 7 provinces
Weakest public listings backstopped by strategic investors Statedominated financials, financial subsidiaries of SOEs, and other government
entities AMCs, military industrials, etc. material investors in IPOs
2010 ABC listing 50% of allocations to strategics4
Highlights otherwise lukewarm market reception, partys close involvementin/backstopping of market listings
Party retains majority ownership & control of boards
Party no longer in direct control, but able to exert significant influence indirectly
1 Huang(2008)
2 Walter&Howie
3 ChinaMobileProspectus(SECFormF3),filed10/04/00
4 Walter&Howie,178181.
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1 McGregor(2011),85
Govt. has largely withdrawn from direct
management but asserts equity ownershipindirectly via personnel appointments:
2 primary levers to control appointments:
Central Organization Department COD
Chinas state Human Resources organization Dictates all meaningful leadership appointmentswithin Party and enterprise system Thought to control 70mm jobs Senior bank managers must be approved by COD aswell as PBOC and special banking committee
Committee on Discipline Inspection CDI Used opportunistically by center to controlproblematic local officials Lacks true independence
overseetheappointmentsofUSstategovernorsandtheirdeputies;themayorsofbigcities;headsoffederalregulatoryagencies;
thechiefexecutivesof GeneralElectric, ExxonMobil, Walmart and50-oddoftheremaininglargestcompanies;justicesonthe
SupremeCourt;theeditorsof TheNewYorkTimes, TheWallStreetJournal and TheWashingtonPost,thebossesofthetelevision
networksand
cable
stations,
the
presidents
of Yale and
Harvard and
other
big
universities
and
the
heads
of
think
-tanks
such
as
the BrookingsInstitution andthe HeritageFoundation.1
A hypothetical American equivalent of the COD would:
TheCODsdiscrete,featurelessBeijing
headquarterslacksanysignage
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1 TheodorGroves,Yongmiao Hong,JohnMcMillan,andBarryNaughton, ChinasEvolvingManagerialLaborMarket,JourneyofPoliticalEconomy103(4)87392(1995)
Executives at SOEs are frequently rotated betweenposts at the CODs behest:
Average SOE executive tenure 5.5 years1
Personnel transfers contravene corporate governancerequirements of public listings
Where party and industry intersect, legal obstacles aremere formalities
Selectedpersonnelappointmentssince2000:
China Mobile, China Unicom, & China Telecom CEOs switched places without warning to break upemerging centers of power
Heads of 3 airlines rotated to reduce price competition
Vicegov. of PBOC made CEO of China Construction
Bank As if Janet Yellen was given Jamie Dimons job
CNOOCs chairman appointed governor of HainanChairman of Huaneng Power made dep. gov. of Shanxi
Chairman of Chinalco elected to cabinet advisory post
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54 of 100 SOEs on central nomenklaturalist1
Chairman/CEOs hold ministerial rank and selected by COD Less powerful StateOwned Asset Supervision & Administration
Commission SASAC selects CFOs/VPs Especially influential in Big 4 banks
Party Committees formed within large companies to insurepolitical correctness/policy implementation Committees active even in foreign businesses / JVs Sleeper cells introduced postTiananmen to be activated during crises
Politicization of management creates problematic
conflicts: Can a bank manager refuse a loan to an executive with greater
standing in the party?
SOEs used to propup failing cos. via strategic investment2
China Mobile Purchased 20% of Shanghai Pudong Devleopment Bank for $5.8bn China Unicom Rumored to have invested in BoCom via opaque subsidiary
Mirrors SOE backstopping of otherwise thinly subscribed equity offerings
The Red Machine Top executives at largest SOEs reportedly receive an encrypted 4digit
telephone line the socalled Red Machine3
Communications link between party elite Symbolic of symbiotic state/big business relationship
1 Walter&Howie,169
2 Walter&Howie,192
3 McGregor(2010),78
Theultimatestatussymbol?
Zhongnanhai,theChineseKremlin
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Source:WorldBank,Bloomberg
ReflectsROEof Nikkei225,DAX,CAC40,HangSeng ChinaEnterprises,KOSPI,MICEX,FTSE100,BOVESPA,SENSEX,IBEX35,S&P100,JakartaCompositefirms,exfinancials.
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%
3YearAverageGDPGrow
th
3 Year Avg. Return on Equity
Despite significantly higher GDP growth Chinese firms lag emerging market peers
as well as some developed markets in return on equity
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1 Madar,Daniel,BigSteel:Technology,TradeandSurvivalinaGlobalMarket,(Vancouver:UBCPress,2009)116. Assumesminimumefficientscaleat5mmt(conservative)2 WorldSteelAssociation
Chinas steel industry is indicative of the dangers ofthe state controlling enterprise:
Industry demands scale but fragmentation increasing: Top 5 producers 1/3rd in 88, only 1/5th in 08 Contrasts with global consolidation trend Fragmentation driven by meddling of local officials
Highly fragmented and inefficient
Economies of scale limited due to state price controls Estimated that only of Chinese steel mills
1
Surplus capacity and continuing irrational growth Capacity EU Japan Russia US combined2
Significant idle capacityOnly 5% of steel exported
Predominantly lowgrade long products Limited valueadd, must import higher grade flatproducts
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Inefficient industry aided and abetted bypervasive accounting fraud: 99% of SOEs have falsified accounts to some
extent1
Sloppy due diligence, weak disclosure,
limited scrutiny by underwriters Regulatory report issued in late March
criticized 17 banks for listing practices
Recent frauds unnoticed by highprofileauditors and investors in the west LongTop, China Media Express, SinoForest, etc.
Reflective of undue Western optimism?
in frauds Cash holdings significantly overstated by
corporates brazen, easily falsifiablemisrepresentations
17 SOEs have admitted to misreportingfinancial data in 20112
Hong Kong Stock Exchange acceptsChinese auditors as of late 2009
Chinesefraudshavepassedmusterwithsomeofthe
Westsmostrespectedauditorsandexchanges
1 Shih(2007),175,GordonChang,TheComingCollapseofChina (NewYork:RandomHouse,2001)2 JamesGrant,GrantsInterestRateObserver,6/3/2011,NationalAuditOffice.
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1 NewYorkTimesDealbookChineseReverseMergerCompaniesDrawLawsuits,7/26/11. Accessed8/23/11,http://dealbook.nytimes.com/2011/07/26/chinese reversemergercompaniesdrawlawsuits/
0.00
0.50
1.00
1.50
2.00
2.50
3.00
Chinese Rev.Merger Index
Russell 2000
TheInfamousChineseReverseMerger
Pervasive accounting fraud in USlisted Chinese stocks Exchanges have halted trading pending outcome of SEC investigations Accounted for almost 50% of federal securities classaction lawsuits in 2011 YTD1
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Lax accounting standards facilitate a large market for off
balance sheet finance:
Entrusted Loans Corporate/household depositors contribute funds to trusts managed by bank
Proceeds loaned to 3rd party borrowers
Circumvents interest rate caps and lending quotas imposed on banks
Bank earnings increasingly driven by off balance sheetvehicles Entrusted OBS loans est. at ~8% of all lending in 2010 1
OBS loans up in 20112
Reportedly 40% of entrusted loans go to property developers3
Figures represent only officially recognized OBS vehicles
Bogus Trade Finance Phony invoices reportedly used to import physical commodity
assets that can be levered Favored by property developers maxed out in aboveground
domestic/offshore markets Also used to circumvent capital controls
Copper favored previously, Soy increasingly popular
Enormous contingent liabilities Undrawn credit commitments at Big 4 RMB 7.4 trn 18%of
GDP!4
Loandocs.fora36mo.entrustedloan
forRMB300mmtermloanwithRMB
3,000mmrevolverfortheconstructionof
acoalgasificationplant.
1 PBOC
2,3 HenrySanderson,OffBalanceSheetLoansDouble,BoostingBankDefaultRisk,BloombergNews,6/23/11,Accessed8/23/11.http://www.bloomberg.com/news/2011 0623/offbalancesheetloansdoubleboostingbankdefaultriskchinacredit.html4 JamesGrant,GrantsInterestRateObserver5/20/11.
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V. Structural Vulnerabilities
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Corporate creativity in accountingis mirrored in official governmentaccounts:
Govt. economic figures are forreference only Li Keqiang ), heir apparent to
Wen Jiabao, Chinas reigning technocrat
Official govt. debt RMB 6.5 trn AMC program and other measures reflect explicit intention to minimize stated debts1
Government has significantOBSdebts(2010E): Unfunded MOF receivables and sterilization bills RMB 2.6 trn
AMC debts, 20032005 RMB 2.7 trnNonconsolidated debt of State Ministries RMB ~400bnNonconsolidated local govts. (largely 0809 vintage) RMB ~10 trn Policy bank debt RMB 4.5 trn
Govt. retains ultimate responsibility for state financial system Govt. OBS debt likely 34x officially disclosed debts total debt: ~100+% of GDP2
1 Shih(2007)171
2 VictorShih,LoomingProblemofLocalDebtinChina.AsianWallStreetJournal,2/10/10.
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Consensus view: Govt. can recap. financial systemwith enormous foreign exchange reserves
Reality: Debts vastly understated, ability to deployforex reserves domestically is limited
Investing forex reserves domestically would unwindliquidity overhang on PBOC balance sheet
Portion of reserves already invested domestically,including holdings of bank equity
Suggests only a fraction of reserves could be
quickly deployed to recapitalize the bankingsystem / arrest an evolving systemic crisis
Chinas fiscal position is a complex web of offbalance sheet entities and unfunded commitments
Headline debt/GDP grossly understates liabilities State enterprise system de facto liability of the state
Ultimate liabilities of Chinese stateare
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Enormous inequality concentrates wealth
1% of Chinese households 0.4% of populationcontrol upwards of $35 trillion depending onassumptions1
Reallocating 3040% of this wealth overseas woulddrain majority of domestic reserves2
Negative deposit rates and limited channels fordomestic investment promote capital flight
Weakening returns on domestic equities, real estateshould accelerate capital flight
Capital controls are porous, particularly for wealthyand politically connected
Underground banks / moneychangers
Bogus trade invoicing
Increasing currency liberalization
Evidence suggests capital flight is already underway
Increasing investment by Chinese nationals overseas
Real estate in US, Canada, Singapore, Australia, etc.
1,2 VictorShihHighWealthConcentration,PorousExchange Control,andShockstoRelativeReturn:TheFragileStateofChinasForeignExchangeReserve. PresentationattheInstituteofNewEconomicThinking,Bretton Woods,NH04/09/11
2 CNTV,ChinesePeopleInvestMoreinRealEstateAbroad. 4/11/2011, accessed8/23/11. http://www.china.org.cn/video/201104/11/content_22330861.htm
USrealestatebrokerscourtingChineseinvestors
Chinesebuyers
accounted
for
almost
11%
of
US
real
estatetransactionsin20113
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VI. Conclusion
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While progress has been made, China effectivelyremains a command and control economy at heart:
No more central planners, but party distorts mostcritical market prices/mechanisms
A China bull must believe in stateled capitalallocation and that it can be successful on a scaleunprecedented in human history
How is this different from the old days?
China is more radical The State wants to lead everything.This is the greatest difference
Yuan Weishi, Zhongshan University1
1 McGregor(2010)78.
2 CIA
Precedent: The Soviet Union managed thesame feat in the 50s ~7% compound
growth by boosting investment spending2
As If All This Wasnt Enough
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As If All This Wasn t Enough
Chinas demographic dividend is fading: Population of working age projected to shrink at 0.1% p/a from 20152025 1
Significant reversal of previously benign demographic trends
One child policy has created gender imbalance
117:100 male/female ratio in 2010 40 mm more men than women by 20202
Increasing social unrest 80,000 mass incidents in 07, up from 60,000 in 06
No recent official data but leaked data suggests as many as 125,000 incidents in 083
Recent surge of incidences including suicide bombings
Has led to increasingly violent crackdowns
Harassment of foreign journalists, arrests of intellectuals and activists,resurgence of Maoism 4
State has increased allocation to state security 14% in latest budget5
1 UNPopulationDivision,StandardChartered,TheEconomist.
2 ChinaFearsBachelorFuture. BBCNewsOnline,4/5/2004.
3 WaveofUnrestRocksChina. TheWallStreetJournal,6/14/2011.
4 Princelings andtheGoonState. TheEconomist, 4/14/2011.
5 ChinasSecurityState:TheTruncheonBudget. TheEconomist, 5/10/2011.
Lackofconcernforhumanrights
Extensivestatecensorship
Laxenforcementofintellectualproperty
Lackofinnovation
UnauthorizedAppleStoerinKunming
How Now Brown (Red) Cow?
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How Now Brown (Red) Cow?
China has before it two alternate paths:1. Status quo
Unsustainable, unfair, unbalanced, and inflationary
System incapable of surviving slow global growth environment Inflation will continue to mount, inflame social tensions, and undermine party credibility Sheer scale creates upper bound to capital/resource intensive growth model Debt financed growth + poor capital allocation + low recovery rates + understatedinflation recent economic growth is likely overstated & perhaps altogether illusory
2. Structural reform
Reforms required are inherently longterm unlikely to ease immediate pressures Would require party to drastically reshape relationship to state and enterprise
Significant relinquishment of power & effective admission of failure by CCPSignificant impediments:
Dependency on domestic savings for financing Fundamentally uncompetitive industry Entrenched political/bureaucratic incumbents inhibit rapid/effective reform Unresolved liquidity overhang on PBOC balance sheet
Significant human capital deficit from chronic social underinvestment Mounting pile of unresolved bad debts stretching ~20 years
Acknowledgements
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Acknowledgements
I would like to dedicate this presentation to thecourageous efforts of Chinas private sector business menand women, who have frequently persevered despite the bestefforts of the corrupt, arrogant, and repressive regime of theCommunist Party.
This document owes a significant intellectual debt to thework of many but I would like to especially recognize thecontribution of the following scholars:
Carson BlockJames Grant Fraser Howie Yasheng Huang Victor Shih Carl Walter
Dali Yang
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