Carl Walter and Fraser Howie’s Red Capitalism: The Fragile Financial Foundations of China’s Extraordinary Rise is a hard book to review. It follows the style of the fox more than the hedgehog; with so many useful figures, facts, and insightful asides between its covers it is impossible to reduce the book to a summary of main themes without eliminating most of what makes the book so interesting. Instead of trying to write one of these reviews I think it wiser to simply copy the passages I found most interesting and share them with readers here. The list that follows does not cover all of them–some passages are too large to copy here, and I have not attempted to reproduce any of the book’s hundred charts, graphs, or tables–but what is included will be useful to those who wish to understand China’s enigmatic regime.
To understand the Chinese economy you must understand that there are really two Chinese economies. One mustn’t confuse them with each other:
“There is a parallel economy that is geographic as well as politically strategic. This is commonly referred to as the economy “inside the system,” (tizhinei 体制内) and from the Communist Party’s viewpoint, it is the real political economy. All of the state’s financial, material, and human resources, including the policies that have opened the country to foreign investment have been and continue to be directed at the “system.” Improving and strengthening it has been the goal of every reform effort undertaken by the Party since 1978. It must be remembered that the efforts of Zhu Rongji, perhaps China’s greatest reformer, were aimed at strengthening the economy “inside the system,” not changing it.” (p. 8)
Westerners often describe China’s explosive economic growth as a product of its export sector. This sector, however, is not “in the system”:
“The private export oriented sector suffered massive losses in jobs, earnings, and the closure of small companies in 2008 and 2009. But China’s banks were not exposed in any material way to this sector. It is simple fact that China’s financial system and its stock, bond, and loan markets cater only to the state sector, of which the “National Champions” represent the reddest of the Red. These corporations, the heart of China’s state owned economy, are “inside the system.” The private economy, no matter how vibrant is “outside the system,” and in fact serves the will of the system.” (p. x)
When analyzing the Chinese economy, appearances can be deceiving:
“Over the past 30 years China’s state sector has assumed the guise of Western corporations, listed companies on foreign stock exchanges and made use of such related professions as accountants, lawyers, and investment bankers…. But these companies are not autonomous corporations; they can hardly be called corporations at all. Their senior management, and indeed, the fate of the corporation itself, are completely dependent on their political patrons. China’s state owned economy is a family business and the loyalties of these families are conflicted, stretched tight between the need to preserve political power and the urge to do business. To date, the former has always won out.” (p. 23).
That is the central reason financial reforms pushed by Chinese reformers inevitably devolve into watered-down half measures:
“Failure to follow through may have been inevitable, however, given the fragmented structure of the country’s political system in which special interest groups co-exist within a dominant political entity, the Communist Party of China. What moves this structure is not a market economy and its laws of supply and demand, but a carefully balanced social mechanism built around the particular interests of the revolutionary families who constitute the political elite. China is a family run business. When ruling groups change, there will be inevitable change in the balance of interests; but these families have one shared interest above all others: the stability of the system. Social stability allows their pursuit of special interests.” (p. 21).
“In China the banks are the financial system: nearly all financial risk is concentrated on their balance sheets. China’s heroic savers under-write this risk: they are the only significant source of capital “inside the system” of the Party controlled domestic economy. This is the weakest point in China’s economic and political arrangement, and the country’s leaders, in a general way, understand this. This is why over the past 30 years of economic experimentation they have done everything possible to protect the banks from serious competition and from even the whiff of failure. In spite of the WTO, foreign banks consistently constitute less than two percent of total domestic financial assets: they are simply not important. Beyond the pressure of competition, the Party treats its banks as basic utilities that provide unlimited capital to cherished state owned enterprises.” (p. 25).
This becomes obvious when you compare the amount of capital raised in the Chinese stock markets with that in the bank-controlled bond market:
“If one looks at incremental capital raising, it is obvious the stock markets in Hong Kong, Shenzhen, and Shanghai are an afterthought. It is bank lending and bond issuance that keep the engines of China’s state own economy revving at high speed. For example, 2007 was a record year for Chinese equity financing: more than US$123 billion was raised, but in the same year, banks extended new loans totaling US$530 billion and debt issues in the bond market accounted for another US$581 billion. In the past decade, equity as a percentage of total capital raised has been measured in the single digits compared with loans and debt. Who underwrites and holds all that fixed income debt? Banks hold over 70 percent of all bonds, including those issued by the Ministry of Finance.” (p.29).
One of many passages that has me wondering how Chinese would translate the term shell game:
“The experience of the last 30 years shows that China’s banks and their business model is extremely capital intensive…. The growth model of Chinese banks requires them to come to the capital markets every few years. There is no way out and this will be a long-term overhang on the market. But it is not just the lending of 2009 or even their business model that drives their unending thirst of capital; it is also their dividend policies.… The money paid out in dividends [during 2004-2008] matches exactly the money raised in the markets. What does this mean? It means domestic and international investors put cash not listed in Chinese banks simply to pre-fund the dividend paid out by the bank largely to the MoF and Central SAFE Investment. These dividends represented a transfer of real third party cash from the banks directly to the state’s coffers….
…As for the Chinese state, which holds the overwhelming majority stake in these banks, such payouts mean the banks will require ongoing capital-market funding after their IPOs. This, in turn, means the government must, in effect, re-contribute the dividends received as a new equity injection just to prevent having its holdings diluted. There can be only one IPO for each bank and one infusion of purely third-party capital. [The Chinese are] running a bank that pays dividends to a state that must then turn around and put the same money back again.” (p. 46-47).
The game is necessary because the banks are relentlessly petitioned to lend to SOEs for purely political reasons. The loans are extended even though everyone knows “SOEs don’t repay their loans” (90). Such gross waste can only continue for so long before the great banks are burdened down by billions in non-performing loans (NPLs) and the whole system is threatened with collapse. The Chinese very narrowly avoided a crisis in 1998:
“Someone was clever enough to come up with a number purportedly sufficient to raise bank capital to eight percent of total assets, in line with the Basel agreement in international banking standards. The figure turned out to be RMB270 billion (US$ 35 bil). For China, in 1998, this was a huge sum of money, equivalent to nearly 100 percent of total government bond issuance for the year, 25 percent of foreign reserves and about four percent of GDP. To do this the MoF nationalized savings deposits barely belonging to the Chinese people… This washing of RMB270 billion through the MOF in effect made the bank’s depositors—both consumer and corporate—de facto shareholders, but without their knowledge of attribution of rights.” (p. 58).
And in 2000:
“The government was unable to reach a consensus on the valuation of these ‘bad’ loans. After all, these loans had all been made to SOEs which were, by definition, state-owned. Anything less than full value would suggest that the state was unable to meet its own obligations, a position anathema to Party ideologues. But that was just the point: the state was unable to meet these obligations. So instead of bankrupting all SOE borrowers—that is, basically the entire industrial sector—the Party chose to keep the losses concentrated on bank balance sheets. Instead of resolutely addressing the problem by writing the loans down, it decided to push the matter off into the future and on to some other politician’s agenda. Of course, in 2009 the Party decided to do the same thing, so the AMC obligations were pushed off a further 10 years. This is how things work “inside the system” (p. 56).
Those toxic loans from the 1990s are still on China’s bank balances. The 2008 recession was a great opportunity to pile even more fuel on the fire:
“Added to the still unresolved loans of the 1990s, US1.4 trillion lending binge of 2009 will inevitably lead to correspondingly larger losses in the future.… a large portion of these loans, 30 percent of which reportedly went to localities, are already in default” (p. 67).
The local government’s response to stimulus spending spree are a case study in perverse incentives:
“The global financial crisis of 2009 posed the greatest challenge yet to the [local governments]: Beijing’s RMB4 trillion (US$486 billion) stimulus package required local governments to identify projects and come up with financing for two thirds of project spending. For some time before the crisis, local governments had been leveraging their utilities, roads, construction brigades and asset management bureaus by incorporating them into limited-liability companies. Under this legal guise, they could borrow money from banks and, taking advantage of bond market reform, issue debt. According to the CBRC, by June 2009, there were 8,221 fund raising platforms operating are provincial, regional, county, and municipal levels, on which the majority (4,907) were owned by country governments. Many of these entities had been established simply to take advantage of the government’s free for all lending boom. After all, if they could come up with the capital to meet Beijing’s demands, why not raise more to finance their own economic incentive programs?” (p. 121).
“In our country’s current level of economic development we must maintain a level of macroeconomic growth around eight percent 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” (p. 44).
The authors interpret this to mean:
“In other words, bank lending is the only way to achieve eight percent GDP growth” (p. 44).
But the debt situation in China is unique–the conditions that lead to China’s recurring debt problems bare little resemblance to the famous international debt crises of the last two decades:
“China relies on “indirect” financing to achieve its economic growth goals. This means that banks decide on behalf of depositors how, to whom, and under what condition to lend deposits out. In a capital market model there is less room for such intermediaries: the end investor is independent of the debt or equity issuer and makes investment or divestment decisions based on considerations independent of the interests of the issuer or the borrower. In China this is not the case: the Party controls the banks and the banks lend, as directed, to state owned entities.
This is precisely where China differs from Mexico of 1994, Argentina of 1999 and Greece and Spain today. Aside from trade finance, China does not borrow money overseas and, because of the non convertibility of the RBM, off shore investors are overwhelmingly excluded from the domestic capital markets. Nor are foreign banks competitive in the domestic load and bond market, given their need to make an adequate return on capital. As a result, foreign banks rarely contribute more than two percent to total financial assets in China.” (p. 206).
Its worth reminding ourselves where this money does comes from:
“The fact that it is well insulated from outside markets does not mean that China’s fiances are crisis foolproof. The system can be disrupted by purely internal factors, as it clearly has been in the past. Take, for example, household savings, pension obligations, and interest rate exposure. Household savings are the foundation of the bank’s capacity to lend. The heroic savings of the Chinese people is virtually the only source of non state money in the game.” (p. 207)
(Note: What the authors overlook here is that savings rates, in China as elsewhere, are not just the product of ‘internal factors.’ China’s saving rate has just as much to do with consumption and investment rates in America or Europe as it does with internal policy decisions).
Howie and Walter also have a few insightful things to say about the Chinese stock market:
“Can a JPMorgan, with 100 percent of its shares capable of being traded in the market each day be compared to banks such as ICBC that have less than 30 percent of their shares tradable?” (p. 36)
“Since China’s stock markets… are not places that decide corporate control, the pricing of shares carries little weight when thinking about the whole company because it is never for sale” (p. 19).
If this is true, what is the purpose of selling SOE stocks in the first place?
“The share valuation mechanism set by the CSRC explains the popularity of IPOs in China. Simply put, prices are knowingly set artificially lower while demand is set high, with the result that big price jumps on listing day are virtually guaranteed. …What [these listings] show is that the state’s confidence in its own ability that, when push comes to shove, it can manage the market index so that it will go up and the state’s holdings will increase in value.” (p. 184-185).
An excellent example is the IPO of PetroChina:
“As indicated, PetroChina’s cheap pricing meant that it had left RMB 45 billion (US $6.2 billion) on the table. Not surprisingly, on its listing, PetroChina’s shares jumped nearly 200 percent, giving it, albeit briefly, a market capitalization of more than US $1 trillion. From a developed market viewpoint this was a complete crime… From the company’s point of a view, and astute chairman would have wondered why he had just sold 10 percent of his company at half the value attributed to it by the secondary market. To put it another way, he had sold US$16.8 billion of stock for just US$9 billion. In an international market, he would, no doubt, have fired his investment bankers outright and then been fired by his bored.
But this money, as shown previously, was hardly lost to the state: it had just been given to those state-owned institutions, the group of “family and friends” that had participated in preparing the lottery. From this, it seems that IPOs function as a means to redistribute capita among state entities with, possibly, some leakage into the hands of retail investors and mutual fund holder to sooth things out” (p. 186-187).
The Chinese bond market is just as distorted:
“In China, however, the Party has made sure that it alone, and not a market driven yield curve, provides the definite measure of risk free cost of capital and this measure is based ultimately on the funding cost for bank loans, the one year deposit rate” (p. 85).
An example of the above:
“On December 8, 2009, for example, the entire China inter-bank bond market for corporate bonds recorded only 1,550 trades—this in a market comprising over 9,000 members and RMB1.3 trillion (US$190 billion) in bond value. In contrast the US Treasury market each day averages over 600,000 trades comprising US$565 billion in value. If market participants to not actively trade, how can the price of a bond be determined and serve as a meaning up measure of value?” (p. 93-9).
And now for the consequences of these distortions:
“The absence of market trading limits the price-discovery function of China’s bond markets. In turn, unreliable prices mean that the market participate cannot value risk accurately. A simple question such as how much a AA issuer would have to pay investors to but its 10 year bonds cannot be answered with any certainty. On the other hand, China’s market investors don’t really care. Why should they when the majority of bonds offer “riskless” yields well over the one-year bank-deposit rate of 2.25 percent, but at the same time, well under demand in the secondary market? As long as inflation remains under control, why shouldn’t banks be happy to hold the bulk of these securities to maturity just as they do their loan portfolios?” (p. 98-99).
A comment from the Department of Pithy Insights:
“China’s central bank manages interest rates in order to contain change because change is risk” (p. 108).
And now one from the Department of Pithy Questions:
“When PetroChina acquires companies overseas on behalf of the government, isn’t also a sovereign wealth fund? What in China isn’t a sovereign wealth fund?” (196).
Where did the Chinese get the expertise they needed to create these globe spanning SOEs?
“New China of the twenty first century is a creation of Goldman Sachs and Linklaters & Paines of the world…. If there is a single reason why the world is in awe of China’s economic miracle today, it is because international bankers have worked so well to build its image so that minority stakes in its companies could be sold at high prices, with the Party and its friends and families profiting handsomely” (p. 159).
One often hears about how Xi Jinping holds the CPC in an iron grip. I will start believing that once this has stopped:
“The profit made by these nominally state owned enterprises is not small and in recent years has reached almost to 20 percent of China’s national budget expenditures. This is a vast amount of money that would be better redirected at the country’s burgeoning budget deficit… The fact that the government is unable to access this capital is the best illustration of the power of these oligopolies” (p. 170-171).
File under “quote this next time someone claims Beijing’s foreign reserves will save the world”:
“China’s massive foreign exchange reserves give a false appearance of wealth: at the time the PBOC acquires these foreign currencies it has already created renminbi. Under what conditions can these reserves be used again domestically without creating even larger monetary pressures?” (p. 73).