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. THIS PRESENTATION IS INTENDED FOR INFORMATION PURPOSES ONLY AND DOES NOT CONSTITUE INVESTMENT ADVICE, A RECOMMENDATION, SOLICITATION, OR OFFER AND IS NOT THE BASIS FOR ANY CONTRACT TO PURCHASE OR SELL ANY SECURITY OR OTHER INSTRUMENT. I, AS WELL AS PERSONS ASSOCIATED WITH MYSELF, MAY MAINTAIN POSITIONS IN SECURITIES, INSTRUMENTS, AND/OR MARKETS REFERRED TO BY THIS PRESENTATION.
¾ Questions, comments, and all other inquiries should be directed to npoling@gmail.com
•
Macroeconomic Review – Growth Drivers – Monetary Policy & the Currency – Social Implications
•
Banking & Finance – The Role of the Central Bank – Regulatory & Market Structure
•
Party & State – Outline of Political System – A Brief History of Reform
•
Industry & the State
•
Structural Vulnerabilities
•
Summary & Conclusion
Ren Xiong (18231857) 任熊 Late Qing dynasty painter of the Shanghai school
•
Since reform began in 1978, China has achieved spectacular growth: –
9.8% annual growth since 1978 • •
–
World’s 2nd largest economy in 2010 World’s 18th 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
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 Malaysia
4000
2000
0 1980 In billions of USD Source: IMF
1985
1990
1995
2000
2005
How has this been achieved so quickly? China’s Share of World GDP – 1978‐2010 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
Source: IMF
How has China gone from being an economic backwater to threatening American supremacy in just 30 years?
2007
Maintain weak renminbi RMB to preserve export competitiveness Restrain inflation Achieve consistent growth 7‐8% explicit target
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 achievable only due to the state’s coercive power and its dominance of domestic markets 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) 3 – A. Rose, “Exchange Rate Volatility, Monetary Policy, and Capital Mobility: Empirical Evidence on the Holy Trinity,” NBER Working Paper 4630 (1994)
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 • Inherently inflationary; impact must be compensated for • Impact ‘sterilized’ by removing currency from circulation by:
• Purchase of foreign assets (i.e. US debt) • Direct & indirect bank reserve hikes
• 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)
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
… and Eating It Too • The mechanics of sterilization: • Chinese exporters receive USD from US buyers • Exporter sells USD to PBOC • Exporter receives newly created RMB from PBOC in return • Printing RMB offsets natural currency adjustment / balancing
• PBOC accumulates USD reserves, RMB supply increased • Reserves parked largely in US Treasuries • Lack of sufficiently large/liquid alternatives
• Reserves deployed increasingly aggressively via sovereign wealth funds etc. • Newly‐printed RMB ‘sterilized’ • Requires financial repression: • Restrictions on banking sector/ general populace • Ultra‐low yielding securities forced on domestic banks by PBOC – effective reserve hikes
A Brief History of Chinese Currency Manipulation
US & Chinese Monetary Aggregates Imported US monetary policy is inappropriate for a fast‐growing emerging economy, particularly one with a history of problematic inflation… 14,000.0
12,000.0
35.0%
Massive fiscal stimulus – 14% of GDP! (US stimulus – 6%)
30.0%
10,000.0
25.0%
8,000.0
20.0% US M2
6,000.0
15.0%
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…
China M2, USD US YoY China YoY
Free from the rule of law, China has used financial repression to limit the inflationary impact of aggressive 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 immobilize bank 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 12/31/10
2
• ~30% of bank capital immobilized • Inflationary pressures continue nonetheless…
1, 2 ‐ PBOC 2010 Annual Report, China Banking Regulatory Commission
•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
Current PBOC Governor Zhou Xiaochuan (周小川)
underground banking system
• 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 1 – PBOC Statistics & Figures 2010
Foreign Exchange Reserves – 19992011 3,500 3,000 2,500
At 6/31/11 China’s reserves were: 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
Billions of USD Source: China Economic Information Network, Bloomberg
12/1/2005
12/1/2007
12/1/2009
• 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%
15.00%
Household Savings Deposits 1 Yr. Rate China 1 Yr. Lending Rate
10.00%
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)
Deposit Reserve Ratio
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% 3000 25.0% 2500 20.0%
15.0% 1500 10.0%
500
5.0%
0
0.0%
Source: US Treasury, billions of USD
US Debt to China US Debt to Japan China, % of Tot.
2000
1000
US Debt, Held by Foreigners
Japan, % of Tot.
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
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…
“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 7.00%
6.00%
5.00%
SHIBOR 3 Mo.
4.00%
Deposit Rate 3 Mo.
3.00%
2.00%
1.00%
0.00% 10/8/2006
4/8/2007
10/8/2007
4/8/2008
10/8/2008
4/8/2009
10/8/2009
4/8/2010
10/8/2010
4/8/2011
Source: PBOC, Bloomberg
Inter‐bank rates (SHIBOR) understate true market rates‐ anecdotal evidence of rates in shadow banking system >20% in 2011…
30.0%
25.0%
20.0%
15.0% CPI, YoY CPI, Urban, YoY CPI, Rural, YoY 10.0%
5.0%
0.0% 1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
-5.0% Source: PBOC, Bloomberg
• Previous inflationary surges managed by extraordinary financial repression (i.e. total halt of bank lending, sweeping centralization of financial and fiscal authority, etc.) • Unclear if current 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 investment1: • Export production capacity • Real estate
–
Significant leverage to global demand
–
Investment increasingly compensating for weak global demand: • •
~70% of 2008 growth ~90% of 2009 growth2
1 – Moody’s Analytics Report “China: Fixed Asset Investment”. Published 6/13/2011. 2 – Pivot Capital Management Report‐ China’s Investment Boom: The Great Leap into the Unknown (2011), National Bureau of Statistics
•China lacks meaningful growth drivers outside of exports and state‐driven investment
•
Exports & Gross Capital Formation / GDP – 1981 ‐ 2009 90%
80%
70%
60%
Global downturn literally paved over: 50%
Gross Cap. Form. (Fixed Asset Investment)
40%
Exports
30% Combined 20%
10%
0% 1981 Source: World Bank
1986
1991
1996
2001
2006
• Real estate is another significant destination for fixed asset investment: •HSBC estimates total value of residential property at 3.27x GDP1 • 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 • 9x in London, 12x in Los Angeles in 2007
1 – HSBC Global Research Currency Weekly, 06/07/2010, p. 5 2 ‐ David Pearson, “In China, Real Estate Fever is Rising”, Los Angeles Times, 04/26/2010. Accessed 8/24/11. http://articles.latimes.com/2010/apr/26/business/la‐fi‐china‐realestate‐20100426 3 – Pivot, p.7. Charts excerpted from same report.
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:
Goldin Finance 117, Tianjin– 117 floors, 597m – under construction. Master plan also calls for 2 70 story towers and residential highrises
Ping An Insurance’s new Shenzen headquarters – 115 floors, 648m – 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:
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 •
State uses market mechanisms selectively & on its own terms
• Experience of other Asian ‘tigers’ suggests growth will slow irrespective of internal obstacles1 • ‘Middle Income Trap’ • 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 – –
•
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
State must withdraw from capital allocation – – –
•
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
State remains dominant player in finance & industry State investment crowds out private entrepreneurs Non‐state sector starved of capital and resources
PBOC must curtail its market operations – – –
Economy must rebalance away from exports / investment Massive balance sheet expansion takes place of increased domestic spending, creates dangerous liquidity overhang Benefits of exports accrue largely to foreign investors and state‐owned enterprise
•
Populace has not shared in gains from growth: – –
•
Personal income/ capita severely lags GDP/Capita growth, 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% flows through to labor Labor’s slice of the pie is shrinking2: • •
•
Large wealth inequality – –
0.4% of Chinese control 40‐50% of wealth3 Gini coefficient: 47 in 2010 according to state ests.4 • •
•
1997 Wages/GDP: 53% 2007 Wages/GDP: 40%
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?
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
Source: World Bank Development Indicators, 1975‐2008.
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) 4 – Chen Jia, “Country’s Wealth Divide Past Warning Level”, China Daily, 05/12/10. Accessed 08/23/11. http://www.chinadaily.com.cn/china/2010‐05/12/content_9837073.htm
Mexico
China
•
Since the early ‘90s, China’s urban populace has been favored at the expense of their poorer, less educated rural compatriots: –
– – – –
•
Huoku 户籍) rural/urban class register system exacerbates divide – – – –
•
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
Rural citizens literally ‘second class’ citizens with restricted mobility Creates marginalized class of 150mm migrant rural laborers 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
Privatizations of ‘90s ended ‘Iron Rice Bowl’ 铁饭碗) social security net • SOEs used privatizations to jettison low‐productivity workers who had previously enjoyed guaranteed jobs & benefits • Restructuring carried out to enhance profitability of retained SOEs • Created large group of unemployed with limited marketable skills/experience – structurally unemployed • ~100mm terminated workers from ‘90s streamlining remain largely unemployed wards of the state 1 – Yasheng Huang , Capitalism with Chinese Characteristics: Entrepreneurship and the State (New York: Cambridge University Press, 200) 251. 2 – Jason Gale & Bret Okeson. “China Doctors Earning $300 a Month Flock to Drug Companies,” Bloomberg Businessweek, 7/10/11. 3 – Carsten Holz, “China’s Economic Growth 1978‐2025: What We Know Today About China’s Economic Growth Tomorrow” Hong Kong University of Science & Technology, 2005.
•
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 •
•
Increasing demands on local leaders paid for through unsustainable financing practices: – –
Land sales of expropriated property frequently used as source of cash flow Arbitrary seizures of peasant farmland, property re‐sold to developers by local government •
•
Incentivized to favor short term economic growth over long‐term social investment
70mm farmers have lost their land in this way in the past decade!
Aggrieved citizens have little recourse as the local government’s word is law –
Seeking justice higher up the state hierarchy difficult and dangerous
•
Healthcare –
– – –
•
2000 World Health Organization study ranked China’s healthcare system 144th globally, behind Burundi but ahead of Mongolia ~40% of sick rural residents did not seek medical care due to its unaffordability1 ~60% of rural residents requiring hospitalization did not seek treatment due to unaffordability1 1 public health professional / 7,000 people US – 1/635 2
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 ’90s3 Inequality continues to rise:4 • •
Lack of training drives inequality in wages5 Illiteracy increased 64.3% between 2000 and 2005 –
•
Equivalent to 30% of rural school cohorts from 1990s6
Rural secondary school dropout rates – 43% in ’00‐’037
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 – Carsten Holz, “China’s Economic Growth 1978‐2025: What We Know Today About China’s Economic Growth Tomorrow” Hong Kong University of Science & Technology, 2005. 4– 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) 5– Z. Liu, “The Effects of Economic Reforms on Wage Inequality: Some Evidence from China,” Applied Economics Letters, 8, (2001) 6 – Huang, 43 7 – Ibid, 248
Patients awaiting treatment
•
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 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 – Alternatives for savers restricted to investment in real estate and equities – encourages speculation – De facto tax on Chinese savers
60.00%
50.00%
40.00%
FDI, % of GDP 30.00%
Gross savings, % of GDP
20.00%
10.00%
0.00% 1982 Source: PBOC, Bloomberg
1987
1992
1997
2002
2007
“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 capital markets) is limited.” – Yang Kaisheng (杨凯生), CEO of Industrial & Commercial Bank of China
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)
Capital Raising Activity – 1993 2009 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
Source: PBOC Financial Stability Report 2010
•The subsidized domestic banking system finances almost all economic activity1: •Bank loans & bonds account for ~90% of corporate finance2 •Equity financing ‐ immaterial •Foreign banks ‐ 2% of financial assets 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)
2008
2009
• 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 banks1 • 22 of 24 primary dealers are state banks1
• 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
• 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 selective adoption of market institutions •
1 – Walter & Howie, 86.
• 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 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 funds almost all economic activity ¾ 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: •Primary tools of state in managing the economy: • A ‘second treasury’ – despite purported commercialization and public listings govt. influence remains significant • 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 6.4% • Emerging rival to Big 4
• Initially formed as state policy banks, later commercialized • 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.
5- Year Asset CAGR
ROA
RE Loans/Total Loans
OBS Commitments/ Total Loans
NPL Ratio
Tier 1 Capital
China Development Bank
21.9%
0.8%
N/A
N/A
0.6%
N/A
Agricultural Development Bank
15.5%
0.0%
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
Bank of China
17.2%
1.1%
29.1%
84.2%
1.2%
10.0%
China Construction Bank
18.7%
1.4%
8.9%
44.0%
1.3%
10.3%
Industrial & Commercial Bank of China
15.8%
1.3%
27.0%
54.3%
1.2%
9.7%
Agricultural Bank of China
16.7%
1.0%
26.6%
14.1%
2.3%
9.6%
Bank of Communications
22.7%
1.1%
9.8%
75.5%
1.1%
9.2%
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). Source: Bank annual reports (various), Bloomberg.
“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 12/31/101: • 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.
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.
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
Proceeds from Sale of Common Stock
100,000
Dividends Paid
0 2005
2006
2007
2008
2009
2010
(100,000)
(200,000)
(300,000) Source: Bloomberg, Bank annual reports
>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
0 Dec-99
Nov-00
Source: PBOC, Bloomberg, billions of RMB
Nov-01
Nov-02
Nov-03
Nov-04
Nov-05
Nov-06
Nov-07
Nov-08
Nov-09
Nov-10
Loan growth has slowed but remains dangerously high… 10.0%
40.0%
9.0% 35.0% 8.0% 30.0% 7.0% 25.0%
Total Loans of Fin. Institutions, YoY (L. Axis)
6.0%
5.0%
20.0%
4.0% 15.0% 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…
NPL Ratio (R. Axis)
• China’s state financial system has historically fared poorly & has a poor 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 impact of new wave of bad loans • Govt. response produced current market structure
• Historical recovery rates in the 10‐20% 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 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
• 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 • International exposure prompted larger concern about 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)
GITIC’S former headquarters; 3rd tallest building in Asia at time of construction
• Prior to GITIC, PBOC closed failing banks and made foreign creditors whole • Comparatively small scale of financial sector / limited international exposure allowed govt. to easily settle the bill • Reflected in bond risk: •8 mos. before collapse, GITIC bonds yielded 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: • 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 govt. • 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 interest rates
1 – Walter & Howie
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 :
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 crisis • Govt. delayed resolution until exogenous shock of AFC demanded action •40% of pre‐2000 loans non‐performing • AMCs acquired RMB 2.4trn of bad loans
• 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
•
Intended as temporary institutions, the AMCs’ 1999 mandate renewed in 2009 for a further 10 years:
• Thinly capitalized; inevitably insolvent • Negligible capital base and inflated purchase price for loans made profitable operation impossible from the beginning • Significant operating expenses exacerbate dearth of loan recoveries • 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
• 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 • Employ 12,000 people • Bad banks now diversified conglomerates • Operating losses worsen already weak financial position
A selection of some of Cinda’s publically acknowledged subsidiaries
Cinda’s operating 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:
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
14.6
57.1
237.1
0.0
331.4
417.3
1,132.2
728.8
8,748.2
9,623.0
11,785.1
8,882.6
2007 PBOC Bills and Bank Sub-Debt
• Bonds rolled with AMC mandate
Total:
• 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
Total Assets: Total Capital: AMC Bonds/Total Capital:
608.3
492.0
586.4
26.3%
50.2%
53.4%
342.8 -
Source: Audited financial statements. 12/31/2009 values.
• Banking system rests on shaky foundation of accounting trickery • Investors aware of potential balance sheet holes but believe in PBOC/MOF ‘put’
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 1st 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 acquired PBOC’s original AMC loans to ease pressure on insolvent AMCs1 • 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)
Financial Regulatory Soup (NDRC, CBRC, CSRC, CIRC)
SOEs
State Council
Ministry of Finance China Investment Corp. (CIC) Central Huijin Investment
PBOC Central SAFE Investment Asset Management Cos. (Huarong, Orient, Great Wall, Cinda, Huida)
‘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 secondary role after suffering a significant erosion of its power in 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: • Generalists: Rotated between ministries and localities • Technocrats: Advance through ‘silo’ hierarchy of PBOC •
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
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 eliminated the possibility of further legitimate reform ¾ 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 •
–
•
Media consensus: if the banks had already been successfully recapitalized, why sell to foreigners?
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: – –
•
PBOC had previously ceded regulatory power over fixed income to a State Planning Commission Creating CP market undermined this authority, generated resentment
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 •
– –
•
9% of CCB sold to Bank of America, 5% to Temasek Singaporean SWF
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 blamed PBOC for rising inflation, accused it of poor management of reserves
It is through CIC that the MOF has enforced its dominance over the PBOC and taken control of the state banks: • 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
• 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 of Huijin and the Big 4 & CDB in turn from the PBOC
• After CIC’s acquisition of Huijin, MOF directly controls Big 4 and CDB • Banking system is now directly owned by state treasury
“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 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: ¾ 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 roles 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
The Hammer & Sickle of the Party
•Party retains power of appointmentwhile 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 its Standing Committee: • Consists of 8 most powerful members of Politburo– China’s ‘board of directors’ • Current membership dominated by disciples of Jiang Zeming • Creates bias towards statist status quo • Meets weekly
•
Unrestricted by the rule of law, Chinese government is inefficient and inequitable: –
China’s constitution is a mission statement rather than a legal document: • •
–
–
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
Petitioners plead for relief from the corruption of local officials
China’s government is not a federal system: • The government relies on negotiated relationships between a wide range 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 – The ‘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 – Wang Jingqiong. “Beijing to Close Thousands of Liaison Offices.” China Daily, 01/25/2011.
•
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 learn and understand the party line – Delegates now acting with increasing independence i.e. abstaining from votes/voting in dissent , but still without any real independent legislative authority
The view from the top
•
In addition to the State Council and the overarching Party superstructure, there is a further level of hierarchical government in China – localities:
•
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
•
Since 2008, permitted to run fiscal deficits – –
•
Shanghai Municipal Government Building
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’
¾ Each of these units exists in various forms, reflecting the ad‐hoc and irregular structure of local governments:
People’s Grand Hall in Chongqing, seat of the local municipal government
1 – “Fitch Warnds Over China Local Government Debt” BBC News, 09/08/11. Accessed 09/27/11. http://www.bbc.co.uk/news/business‐14836386 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/china‐facing‐a‐hidden‐debt‐crisis?videoId=183875158
•
Dire need for reform in aftermath of Cultural Revolution –
•
China came closest to achieving legitimate market‐oriented reform in the ’80s: – –
•
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 –
•
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 – –
•
Economy in tatters, party’s credibility shot after bloodbath led by ‘Red Guards’
Limited private banking, 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 Zhao (top) & Hu – Architects of reform
1 –Minxin Pei, “China’s Trapped Transition: The Limits of Developmental Autocracy,” (Boston: Harvard University Press, 2006) 11.
A Brilliant Idiot:
•
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 RCC/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 TVEs1 • Local govts. 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‐’882
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. 2 – Huang 117.
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
•
Foreign capital systematically favored over indigenous entrepreneurs1
1 – Pei (2006)
“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 sweeping centralization and reversal of earlier reforms
•
Favored urban SOEs and foreign capitalists over indigenous entrepreneurs
•
Rural and urban income growth stalled – – –
•
Govt. bureaucracy ~2x during decade –
•
Administration/fiscal management of rural localities recentralized, lost fiscal autonomy Rural tax burden grew significantly, subsidized urban growth Rural household income grew just 3.8% from ‘89‐’01 – GDP annualized 16.5% same period1
Govt. payroll up from 20mm in the early ‘90s to 46mm in 20042
Significant re‐centralization of finance to control inflation, favor urban SOEs – – –
RFCs curbed in ‘93, banned in ’98, strongly limiting access to finance in rural areas Post 1994, RCC loans required local and regional approval – local autonomy restricted Post 1998, all RCC loans required consent of PBOC
1 – Huang, 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 – Shukai Zhao, “Bianju Zhong De Ziangzhen Jigou [Changing Township Organizations],” State Council Investigation and Research Report 168 (2004)
3
•
4th generation leaders – Hu Jintao & Wen Jiabao – –
•
1st generation to inherit rule as picked successors Reflects increasing ‘bureaucratization’ of party
Recognize challenges but remain wedded to statist policy solutions: – 18th 5 Year Plan reflects this approach: • $1.5 trn in infrastructure spending and targets the development of specific industrial sectors – Unfunded commitment – will likely be financed by banking system
• Emphasis on hard infrastructure; real problems originate in lack of ‘soft’ infrastructure i.e. free markets, rule of law, defined property rights, etc.
•
Pending transition to 5th generation – –
Need to maintain stability and growth Potentially destabilizing political dynamic 和谐 社会 Héxié shèhuì “Harmonious society”
•
What is the current state of Chinese industry?
•
China’s liberalization in the ‘90s proceeded according to the blueprint: – –
•
Divested smaller, inefficient SOEs, concentrated on restructured national champions: – – – –
•
Small SOEs – ~20% of sector in ‘97 but comprised majority of operating losses Small SOEs privatized, laid off 30‐40mm workers Retained SOEs laid off a further 50mm workers to enhance profitability SOEs given tax and debt relief, import licenses, access to domestic and foreign listing facilities, and reduced operating restrictions
Policy of “2 Guarantees” – –
•
‘Let go of the small, take hold of the big’ ‐ 15th Party Congress, 1997 Large corporates remain under government control
Guaranteed access to financing and raw materials for 234 SOEs Strongly limited need to remain competitive
Not true privatization – restructuring used to solidify state control and enhance profitability of remaining SOEs – –
Party retains equity ownership and control via corporate boards and personnel appointments Party committees – political ‘sleeper cells’ established within corporations provide further layer of control to be activated in times of crisis
•
Private sector significantly smaller than headline figures would suggest: – Official definitions are problematic: • ‘Non‐state’ includes many collective enterprises controlled by local government • Majority of listed SOEs are classified as non‐public – However, state retains majority ownership and control of corporate boards
– 2005 OECD study suggests private sector is ~70% of economy1 • Confusion regarding ‘legal‐person’ shareholding firms ~40% of private sector • OECD views as private, but majority of ‘legal‐person’ 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 other SOEs2
– Correcting for this, true private sector is only around 40% of economy2 • Even if we accept the 70% number at face value, share is still low: • Comparable to Indira Ghandi’s India with nationalized banking system and the ‘license raj’
•
Private sector primarily concentrated in capital extensive service sector – Reflects limited access to official sources of financing
1 – Sean Dougherty & Richard Herd, “Fast‐Falling Barriers & Growing Concentration: The Emergence of a Private Economy in China,” OECD Economics Department Working Papers 471 (2005) 2 – Huang 3‐ Ibid, p. 124
•
Majority of listed cos. are state‐owned: – –
Only 7% of 1990‐2003 listings from private cos.1 State sector given preferential access to capital markets •
–
Most competitive of truly private companies remain private, HK‐domiciled
Many ‘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
– 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. in 6 provinces owned by its own parent Prospectus referred to a pro‐forma 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’ –
State‐dominated financials, financial subsidiaries of SOEs, and other government entities AMCs, military industrials, etc. material investors in IPOs • 2010 ABC listing – 50% of allocations to ‘strategics’4 –
•
Highlights otherwise lukewarm market reception, party’s close involvement in/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 2 – Walter & Howie 3 – China Mobile Prospectus (SEC Form F‐3), filed 10/04/00 4 – Walter & Howie,178‐181.
• Govt. has largely withdrawn from direct management but asserts equity ownership indirectly via personnel appointments: • 2 primary levers to control appointments: • Central Organization Department COD • China’s state Human Resources organization • Dictates all meaningful leadership appointments within Party and enterprise system • Thought to control 70mm jobs • Senior bank managers must be approved by COD as well as PBOC and special banking committee • Committee on Discipline Inspection • Used opportunistically by center to control problematic local officials • Lacks true independence
The COD’s discrete, featureless Beijing headquarters lacks any signage
A hypothetical American equivalent of the COD would: “… oversee the appointments of US state governors and their deputies; the mayors of big cities; heads of federal regulatory agencies; the chief executives of General Electric, ExxonMobil, Walmart and 50odd of the remaining largest companies; justices on the Supreme Court; the editors of The New York Times, The Wall Street Journal and The Washington Post, the bosses of the television networks and cable stations, the presidents of Yale and Harvard and other big universities and the heads of thinktanks such as the Brookings Institution and the Heritage Foundation.“1 1 – McGregor (2011), 85
• Executives at SOEs are frequently rotated between posts at the COD’s behest: • Average SOE executive tenure – 5.5 years1 • Personnel transfers contravene corporate governance requirements of public listings • Where party and industry intersect, legal obstacles are mere formalities
Selected personnel appointments since 2000: •China Mobile, China Unicom, & China Telecom • CEOs switched places without warning to break up emerging centers of power
•Heads of 3 airlines rotated to reduce price competition •Vice‐gov. of PBOC made CEO of China Construction Bank • As if Janet Yellen was given Jamie Dimon’s job…
•CNOOC’s chairman appointed governor of Hainan •Chairman of Huaneng Power made dep. gov. of Shanxi •Chairman of Chinalco elected to cabinet advisory post 1 – Theodor Groves, Yongmiao Hong, John McMillan, and Barry Naughton, “China’s Evolving Managerial Labor Market,” Journey of Political Economy 103(4) 873‐92 (1995)
•
54 of 100 SOEs on central nomenklatura list1 Chairman/CEOs hold ministerial rank and selected by COD Less powerful State‐Owned Asset Supervision & Administration Commission SASAC selects CFOs/VPs Especially influential in Big 4 banks
• • •
•
Party Committees formed within large companies to insure political correctness/policy implementation Committees active even in foreign businesses / JVs Sleeper cells introduced post‐Tiananmen to be activated during crises
• •
•
Politicization of management creates problematic conflicts: –
The ultimate status symbol?
Can a bank manager refuse a loan to an executive with greater standing in the party?
No •
SOEs used to prop‐up failing cos. via ‘strategic investment’3 – –
•
China Mobile – Purchased 20% of Shanghai Pudong Devleopment Bank for $5.8bn China Unicom – Rumored to have invested in BoCom via opaque subsidiary
The ‘Red Machine’ – –
Top executives at largest SOEs reportedly receive an encrypted, 4‐digit telephone line the ‘Red Machine’ Communications link between party elite • Symbolic of symbiotic state/big business relationship Zhongnanhai, the ‘Chinese Kremlin’
1 – Walter & Howie, 169. 2 ‐ McGregor (2010), 78 3 – Walter & Howie 192
12.0%
3 Year Average GDP Growth
10.0%
8.0%
6.0%
4.0%
2.0%
0.0% 0.0%
-2.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
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 Source: World Bank, Bloomberg Reflects ROE of Nikkei 225, DAX, CAC 40, Hang Seng China Enterprise s, KOSPI, MICEX, FTSE 100, BOVESPA, SENSEX, IBEX 35, S&P 100, Jakarta Composite firms, ex‐financials.
• China’s steel industry is indicative of the dangers of the state controlling enterprise: •Industry demands scale, but increasing fragmentation: • 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 0.3% of Chinese steel mills are of efficient scale1
• Surplus capacity and continuing irrational growth • Capacity EU Japan Russia US combined2 • Significant idle capacity •Only 5% of steel exported
•Predominantly low‐grade long products • Limited value‐add, must import higher grade flat products
1 – Madar, Daniel, “Big Steel: Technology, Trade and Survival in a Global Market, ”(Vancouver: UBC Press, 2009) 116. Assumes minimum efficient scale at 5mmt (conservative) 2 ‐ World Steel Association
•
Inefficient industry aided and abetted by pervasive accounting fraud
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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 high‐profile auditors and investors in the west Long Top, China Media Express, Sino‐Forest, etc. •
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Banks complicit in frauds –
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Reflective of undue Western optimism?
Cash holdings significantly overstated by corporate– brazen, easily falsifiable misrepresentations
17 SOEs have recently admitted misreporting financial data1 Hong Kong Stock Exchange accepts Chinese auditors as of late 2009
1 – James Grant, Grant’s Interest Rate Observer, 6/3/2011, National Audit Office.
Chinese frauds have passed muster with some of the West’s most respected auditors and exchanges
The Infamous Chinese Reverse Merger 3.00
2.50
2.00 Chinese Rev. Merger Index 1.50
1.00 Russell 2000 0.50
0.00
• Pervasive accounting fraud in US‐listed Chinese stocks • Exchanges have halted trading pending outcome of SEC investigations • Accounted for almost 50% of federal securities class‐action lawsuits in 2011 YTD
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1 – New York Times Dealbook “Chinese Reverse Merger Companies Draw Lawsuits,” 7/26/11. Accessed 8/23/11, http://dealbook.nytimes.com/2011/07/26/chinese‐reverse‐merger‐companies‐draw‐lawsuits/
Lax accounting standards facilitate a large market for off balance sheet finance: •
‘Entrusted’ Loans – – –
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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 sheet vehicles – –
‘Entrusted’ OBS loans est. at ~8% of all lending in 20101 OBS loans up 110% YoY in 20112
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Reportedly 40% of entrusted loans go to property developers3 Figures represent only officially recognized OBS vehicles
Bogus Trade Finance –
Phony invoices used to import commodity assets that can be levered • •
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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
Loan docs. for a 36 mo. entrusted loan for RMB 300mm term loan with RMB 3,000mm revolver for the construction of a coal gasification plant.
1 – PBOC 2, 3 – Henry Sanderson, “Off‐Balance Sheet Loans Double, Boosting Bank Default Risk,” Bloomberg News, 6/23/11, Accessed 8/23/11. http://www.bloomberg.com/news/2011‐06‐23/off‐balance‐sheet‐loans‐double‐boosting‐bank‐default‐risk‐china‐credit.html 4 – James Grant, Grant’s Interest Rate Obeserver 5/20/11.
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Corporate creativity in accounting mirrored in official government accounts:
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Govt. economic figures are ‘for reference only’ –
Li Keqiang 李克强), heir apparent to Wen Jiabao, China’s reigning technocrat
• Official govt. debt – RMB 6.5 trn •Government has significant OBS debts (2010E): • Unfunded MOF receivables and sterilization bills RMB 2.6 trn • AMC debts, 2003‐2005 RMB 2.7 trn •Non‐consolidated debt of State Ministries RMB ~400bn •Non‐consolidated local govts. (largely ‘08‐’09 vintage) RMB ~10 trn • Policy bank debt RMB 4.5 trn
• Govt. retains ultimate responsibility for state financial system • Govt. OBS debt likely 3‐4x officially disclosed debts total debt: ~100+% of GDP1 1 – Victor Shih, “Looming Problem of Local Debt in China.” Asian Wall Street Journal, 2/10/10.
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Consensus view: Govt. can recap. financial system with enormous foreign exchange reserves
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Reality: Debts vastly understated, ability to deploy forex reserves domestically is limited – –
Investing forex reserves domestically would unwind liquidity overhang on PBOC balance sheet Significant portion of reserves already invested domestically, including holdings of bank equity •
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Suggests only a fraction of reserves could be quickly deployed to recapitalize the banking system / arrest a systemic crisis
China’s fiscal position is a complex web of off‐ balance sheet entities and unfunded commitments Headline debt/GDP grossly understates liabilities State enterprise system de facto liability of the state
• Ultimate liabilities of Chinese state are wholly unknowable
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Enormous inequality concentrates wealth –
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Negative deposit rates and limited channels for domestic investment promote capital flight –
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Weakening returns on domestic equities, real estate should accelerate capital flight
Capital controls are porous, particularly for wealthy and politically connected – – –
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1% of Chinese households 0.4% of population control upwards of $3‐5 trillion depending on assumptions 1 Reallocating 30‐40% of this wealth overseas would drain majority of domestic reserves
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, western Canada, Singapore, Australia, etc.
1 – Shih (2011) 2 ‐ CNTV, “Chinese People Invest More in Real Estate Abroad.” 4/11/2011, accessed 8/23/11. http://www.china.org.cn/video/2011‐04/11/content_22330861.htm
US real estate brokers courting Chinese investors – Chinese buyers accounted for almost 11% of US real estate transactions in 20112
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While progress has been made, China effectively remains a command and control economy at heart: – –
No more central planners, but party distorts most critical market prices/mechanisms A China bull must believe in state‐led capital allocation and that it can be successful on a scale
unprecedented in human history
– Liberalization is meaningless without: • Private ownership • Private capital allocation • Rule of law
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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
Is China’s resilient growth surprising given that it is primarily driven by government financed investment? • Precedent: The Soviet Union managed the same feat in the ‘50s 6.8% compound growth by boosting investment spending2
As If All This Wasn’t Enough… •
China’s demographic dividend is fading: – –
Population of working age projected to shrink at 0.1% p/a from 2015‐20251 – significant reversal of demog. trends! One child policy has created gender imbalance • •
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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 •
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Recent surge of incidences including suicide bombings Has led to increasingly violent crackdowns – •
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No recent official data but leaks data suggests as many as 125,000 incidents in ‘083
Harassment of foreign journalists, arrests of intellectuals and activists, resurgence of Maoism 4
State has increased allocation to state security 14% in latest budget 5
• Lack of concern for human rights • Extensive state censorship • Lax enforcement of intellectual property • Lack of innovation Unauthorized Apple ‘Stoer’ in Kunming 1 – UN Population Division, Standard Chartered, The Economist. 2 ‐ “China Fears Bachelor Future”. BBC News Online, 4/5/2004. 3 ‐ “Wave of Unrest Rocks China”. The Wall Street Journal, 6/14/2011. 4 ‐ “Princelings and the Goon State”. The Economist, 4/14/2011. 5 – “China’s Security State: The Truncheon Budget”. The Economist, 5/10/2011.
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 + understated inflation recent economic growth is likely overstated & perhaps altogether illusory…
2. Structural reform • Reforms required are inherently long‐term – 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 CCP •Significant 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…