Financial Reform In China? Don’t Bet On It.

By Dan Harris on April 9th, 2012 Posted in China Business, Recommended Reading

Much has been written over the past several days regarding Wen Jiabao’s comments on financial reform in China. Particular interest has been focused on his comments regarding breaking up China’s biggest banks. My own view is that the likelihood of such reform in the near future is just about zero. The reason I think this is because carrying out such reforms will require China to reform its entire system of governance and nobody in China is proposing that.

The reason for China’s fundamental difficulty in carrying out financial reform is explained in the book, Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise, by Carl Walter and Fraser Howie. I have been living in China off and on for nearly twenty years and, unlike so many English language books on China, this book describes a China that I actually can recognize. The writers burrow beneath the surface and show what is really going on in China’s financial markets. The reading can be tough in places because the authors support their arguments with detailed financial analysis. The book really should be read twice: a first reading for the basic outline of the argument and a second reading to carefully digest the financial analysis. Criticisms of the book that I have seen simply ignore this hard financial data and dwell on what China must be like in some fantasy world that exists only in the dreams of the critic.

The core argument of the authors is that within the financial markets of China, almost nothing is as it initially appears:

China’s Banks are not really banks.
China’s Stock companies are not really companies
China’s bond market is fake (“Fictional curves from fictional trading”)
China’s stock market is not really a market.

As we pointed out in our recent Rent a Laowai posts (“China: Where Nothing Is Ever Quite What It Seems. The High End Rent-A-Laowai Edition” and “A China Rent-A-Laowai Story To End All Rent-A-Laowai Stories. Trust Me On This One,” nothing in China is what it seems to be. China’s financial markets are no exception.

If the entities are not as described, then what are they? The authors describe all of these pseudo-market players as part of the National System. The function of the National System is to remove money from the pockets of the citizens of China and from foreign investors and to deposit the money into the Communist Party (the CCP) and the State Owned Enterprises (SOEs) and other interest groups controlled by the Party. In the past decade, this system has worked very well.

However, the creation of the National System has nothing to do with capitalism or markets and has everything to do with politics and power. As the authors state, China is a family business:

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. This camouflages its true nature: that of a patronage system centered on the Patrty’s nomenklatura. The huge state corporations have adopted the financial techniques of their international competitors and raised billions of dollars in capital, growing to an economic scale never seen before in all of Chinese history. But these companies are not autonomous corporations; they can hardly be said to be corporations at all. Their senior management and, indeed, the fate of the corporation itself, are 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.

China still continues to grow its GDP at a remarkable rate and it has shown remarkable stability in the face of the world’s recent financial crisis. This has confirmed for many within and outside China that the China family model and the creation of a National System is a sound financial management technique. As many of my friends have commented with respect to Red Capitalism, the National System works for China, so what is the issue? If it ain’t broke, then don’t fix it. The view of the authors is: it is broke, but no one is going to fix it.

Though there are many issues here, Walsh and Howie focus on the main source of risk to the National System: political control of China’s Chinese financial system has resulted in an inability for the players in the Chinese economy to assess risk. This is true with respect to bank lending, the stock markets, the bond markets and property markets. The Chinese view the trends in all of these systems entirely in terms of their relation to the political attitude of the government.

This consistent failure to assess risk has two prominent negatives:

From the standpoint of foreign investors, returns on investment are inherently uncertain because there is no true market price for investments.
More importantly, for China itself, this system is inherently fragile. Though the system works under favorable conditions, it is subject to stagnation and collapse when those conditions change or when the political system is simply unable to provide consistent support.

The entire theme of the China National System as a family business is particularly useful when assessing the recent calls for financial reform in China that have come from outside (the World Bank) and from inside (the comments of Wen Jiabao on breaking up the banks). Most discussion of these issues assumes that China’s goal is to maximize profit in accord with market economy dictates. But, as the quote above makes clear, China does not have a market economy. China has a CCP-controlled patronage system. Frazier and Howie suggest that any attempt at reform will fail because of the political (non economic) demands of that peculiar system.

That is the reality of China and investors and pundits should take that into account.

What do you think?

John P. White

Steve, your comment ”I have been living in China off and on for nearly twenty years” – what does that actually mean? I recently met a New York lawyer who said he’d been dealing with China since 1989. But when prodded a bit it turns out he’d been seconded to their firms Hong Kong office for 6 months back then and visited Shanghai and Beijing each once in the 1990′s and in 2008. Thats not experience dating back to 1989 in my view. So much much of your 20 years was actually “on” and how much was “off”?
Because I think it makes a difference if you’re going to talk about matters like this.

http://www.chinalawblog.com/ Dan Harris

I’m actually the one who put in the living in China off and on for the last twenty years so I’ll answer this by saying that in the last ten years or so, Steve has spent about 99% of his time in the PRC.
r_s_g

Steve Dickinson is most assuredly a serious China watcher.

godfreeroberts

I don’t disagree with the observations That Walter and Howie make about the nature of business in China. But the conclusions they draw are naive. They underestimate the subtlety of people like Deng and his successors who designed (and continue to adapt) the Chinese Unitary State.
Those guys were and are geniuses, if only because that’s almost a prerequisite for reaching the top in China. They gave us a system that looks like Capitalism, and even a share of its spoils, whirl they went about extracting it’s benefits and passing them along to the people. Without a peep of protest from our greed-blinded right wing.
They are deeply committed Communists even though they’re not revolutionaries. They have never deviated from their Party’s ideology. They’re merely taking a longer route to realizing their goals tha Mao would have wished. More power to ‘Em.
Pmaidment

I have long held that the pace of financial reform is primarily a political matter. There are a series of closely connected questions. First, is China’s existing economic model (SOE dominated, fixed-asset investment and export driven) able to continue to deliver the rapid growth the Party needs to legitimize its monopoly rule. If it is, then there is no need for change, and the vested interests, notably the princelings and the military for whom state-directed capitalism is a source of power, money and influence, and the local bureaucrats for whom it means power and promotion, will continue as is.

If, as most of the top economic policymakers in China if not all the top leaders accept, it is not, either because the end of the fast-growth cycle is at cyclically at hand or because such a development model is structurally unsustainable (eventually the accumulated debt comes back to bite you), then the next question is can the SOEs deliver the necessary change? Many of the old guard say yes, citing the resilience of China’s economy since the 2008 global financial crisis that laid low Western economies. Reformers say no, primarily because the old model can’t deal with the challenges of structurally rebalancing the economy so China can take the next step up the economic development ladder, preparing it to vault the middle income gap that the country needs to clear to become a developed economy.

Most reform models to rebalance the economy propose scaling back the SOEs’ share of the economy (50% now, broadly defined, still 40% narrowly). In the face of that prospect, many of the vested interests mentioned earlier have dug their heels in to prevent anything that threatens diminishing their power, money and influence. This is roughly the point we have been at for the past several years, and to my mind explains why financial reform has slowed to glacial pace.

The question the reformers have to answer — which is where the factional political debate shaping the leadership transition now is — can the Party still maintaining its monopoly on political power while controlling, through the state, a smaller share of economic output? Then, if so, how far and how fast dare it go in shrinking the state sector in order to let the private sector create more of the economic growth that the Party needs to legitimize its monopoly on power? Once that is quantified, what will be needed to buy off the vested interests that will lose out from shrinking the state sector.

Only once that question is answered will financial reform move ahead in an meaningful way. The Bao Xilai incident may have opened an opportunity for the reformers to press their case more vigorously (and hence the recent talk of the revitalization of financial reform), but I don’t think it means the questions above have been definitively answered. My guess is that that question isn’t likely to be answered soon. Leadership transitions are a two-to-three year process when they go smoothly, and the current five-year plan lays out the broad shape of the economy until 2015/ Some of the tentative timelines for financial reform coming from reform-minded policymakers in the central bank are looking 10 years down the road.

There are a couple of helpful pieces exploring these themes on the China Bystander blog (full disclosure, as Dan knows, my firm has a commercial relationship with it) How Small Is a Large Role for SOEs and China’s Reform, the World Bank and Vested Interests.
dan berg

“The function of the National System is to remove money from the pockets of the citizens of China and from foreign investors and to deposit the money into the Communist Party (the CCP) and the State Owned Enterprises (SOEs) and other interest groups controlled by the Party.” This is exactly right. How is this done? Through the banking system DESIGNED by those who benefit. How? Deposit interest rates are negative; i.e. lower than inflation, so the billion people who put their wages in the bank draw out less than they put in. Why would they do that? No choice; there is no where else to invest other than the stock market (where they lose) or real estate. If deposit rates are 3%, banks then loan to SOE at 6% and pocket the difference. SOE then invest in real estate, which for years grew at 20-30%.
Chris

Agree with the broad thesis put here that China’s financial markets are pseudo-market-players operating in the interest of a ‘national system’. The survival of foreign and private companies and industries is very much at the whims of a bureaucratic system. Access to financial markets (loans, bonds, IPOs etc) is almost exclusively reserved for SOEs and a few favored private players. Mainstream private firms have a very restricted operating space (and many of them are better off as an outcome having learnt to grow from internal resources). One key demonstrator is the failure of almost any listed Chinese company (most of which continue to be SOEs which minority of listed shares) to actually pay a dividend despite sometime very healthy profits.

However, I do disagree with the thesis that this system exists to benefit a nomenklatura cabal of families. The system exists to protect, grow and develop the state sphere that requires the capital, the human talent and the competitive edge that the pseudo-market delivers. The state sphere is the dominant element here. The parasitic networks of families, connections and hangers-on attached to the system change over time and can only indirectly benefit from the enormous wealth created. A true oligarchy would have privatized the lot a long time ago enabling direct delivery of this vast wealth and power into its own hands.
Twofish

You really want to know what I think?

I used to spend a lot of time talking with Trotskyists. I try to be polite and keep an open mind, but sometimes when someone spouted off about how Albania is a workers paradise, I just have to roll my eyes, and say “Are we *really* on the same planet here?” I get the same feeling when someone is telling me that China has a fragile economy that can’t price risk. It’s as if they have been spending the last five years on Mars.

It’s the same old story. The Chinese economy doesn’t work the way that economies should, so people point out all of these issues and problems and claim that the Chinese economy is *doomed*. Whereas what happens is that people in China look at the problem and fix them and the game goes on. The main purpose of the Communist Party is to stay in power. To stay in power, they have to grow the economy, and the Communist Party is refreshingly non-ideological about how it’s does it. If things get really tough, I suppose the people will take down the red flags, get rid of the Party, but you’ll have the same people running things, which is what basically happened in Russia.

The banks, the stock market, and the corporations in China work differently than the US. But these institutions work differently in every country, and things change over time. If you argue that the Chinese banks aren’t “real” because the government controls interest rates, then you’d have to argue that the US didn’t have any “real banks” in the 1960′s when the US government did the same thing. And those “fake banks” that China has seem to work a lot better than the “real banks” that the US has.

About pricing risk, the Chinese banking system prices risk much better than the US system did in 2005. In 2005, the game was simple. You make extremely risky bets. If those bets worked, you collected your bonus. If those bets didn’t, then the government had a big mess to clean up, but you kept your money. This gave people a massive incentive to underprice risk. Since 2007, the US banking system has been restructured to look a lot more like the Chinese banking system. Now no one will say “we are copying China” just like it’s politically incorrect for anyone in China to say that they are copying Japan. But when China wants to copy Japan, people talk about South Korea, and when the US wants to copy China, people talk about Canada and Sweden.
Twofish

The thing about the Chinese political economy is that there are not just two sides. There are hundreds of different interest groups with different goals and they form rather fluid coalitions. One thing that people should absolutely stop talking about is “reformer’ versus “hard-liner” Chinese politics just don’t work this way, any more than US politics does.

Pmaidment: Most reform models to rebalance the economy propose scaling back the
SOEs’ share of the economy (50% now, broadly defined, still 40%
narrowly). In the face of that prospect, many of the vested interests
mentioned earlier have dug their heels in to prevent anything that
threatens diminishing their power, money and influence.

Those statistics are misleading because you have very unclear definitions of what is an SOE. Any Chinese company that is of non-trivial side is going to be a mix of state and non-state control, and it’s hard to tell which is which. And the coalitions are not obvious. If you go to any Chinese venture capital fund, you’ll find some princeling there, because access to the state is essential for any sort of “private” investment. The argument against privatization of the SOE’s is largely that if you allow that, then it will allow politically well connected people to loot the economy, which is what basically happened in Russia.

One thing about the SOE sector of the economy is that SOE’s have in fact grown a lot. It’s just that other sectors have grown faster.

Pmaidment: Can the Party still maintaining its monopoly on political power while
controlling, through the state, a smaller share of economic output?

They haven’t had any problem controlling the internet. It’s really not hard. If the Party wants to you stop doing something, they don’t worry about board meetings and economic control. They just toss people in jail. End of argument. “Private” internet companies are subject to heavy state regulation, so I don’t think that the form of capital really interacts that much with Party control.

dan berg

But, then again, maybe there are “reformers” and “hard liners;”http://blogs.wsj.com/chinarealtime/2012/04/10/housing-rights-defender-jailed-for-disturbance/

Twofish

Chris: . Access to financial markets (loans, bonds, IPOs etc) is almost
exclusively reserved for SOEs and a few favored private players.

There are financial reasons for this. The problem is that if you let everyone launch an IPO, you end up with a lot of crappy companies, which borrow a ton of money and then go out of business. No one wants a repeat of the .com bubble.

Chris: One key demonstrator is the failure of almost any
listed Chinese company (most of which continue to be SOEs which minority
of listed shares) to actually pay a dividend despite sometime very
healthy profits.

There’s also financial reasons for this. Cash is visible. Liabilities are less visible. The government forces SOE’s to have a large cash cushion which is visible, so that way if something blows up somewhere (i.e. a bad real estate investment that the company “forgot” to tell anyone about) that the company can cover the losses through its cash reserve before the government bails it out. Now, you could argument that the government shouldn’t bail out SOE’s, but once people think that you are too big to fail, then you are too big to fail, and the Chinese way of dealing with TBTF is to have the government force the companies to have large internal reserves.

Also, the big shareholder in the SOE’s is the government, and if the SOE pays the government, then it’s not obvious what the government would do with the money. The other thing is that if you have a lot of cash, that’s more money to pay corporate officers and buy expensive office equipment. If the government randomly takes your money whenever you make a profit, then what’s the point of making a profit. Part of the difficulty in dividend policy is to set things up so that the government *doesn’t* randomly issue itself a dividend, but does this according to predictable rules.

Personally, I don’t think that very much is going to change with the SOE’s, since they were restructured a decade ago, and they work pretty well. They aren’t the big problem, which are local government investment trusts, which is going to have to require a bailout over the next few years.
Twofish

It’s also worth noting that Wen Jiabao was horribly misquoted. He wasn’t arguing for breaking up the banks. He was arguing that banks should play a relatively less important role in the financial system which is rather non-controversial. It’s important to point out that the reason it’s non-controversial is that we are talking about a smaller *relative* part of the pie. The big banks are likely to grow. It’s just that other parts of the financial system are likely to grow faster.

Pmaidment

Spot on. The Wenzhou pilot scheme talks of converting some of the shadow lenders into regional banks. The China Postal Savings Bank could also be given a bigger role. Foreign banks might also be let into the domestic retail market in a small way. It is a huge step from a pilot in Wenzhou to national implementation, of course, but there are options to diversify the banking sector without challenging the big four state owned banks’ market dominance in the near term.
dan berg

Twofish apparently sees his role in this world as obfuscation; America also has SOEs, China also invests in US multinationals. In this particulat instance: “other parts of the financial system are likely to grow faster”; read todays Bloomberg: http://www.bloomberg.com/news/2012-04-10/shadow-banks-on-trial-as-china-s-rich-sister-faces-death.html

Twofish

Just to provide an extreme example of how difficult it is to determine what is an SOE and what isn’t an SOE, the Chinese government indirectly owns small amounts of Coca-Cola ($9 million) and Apple ($6 million).

http://www.sec.gov/cgi-bin/browse-edgar?action=getcompany&CIK=0001468702

Also, there is a lot more state ownership in the United States than most people realize. There are huge state-employee pension funds (Calpers, Federal Retirement Thrift, New York Teachers) etc. etc.

The other thing is that the idea that the “evil old guard” supports SOE’s over the “good reformers” which support American-style capitalism doesn’t quite work. If you look at where the kids of Party members work, they aren’t in the SOE’s, the kids are working in venture capital, investment banking, “private” companies, and all the new sexy nouveau riche stuff where they can drive red Ferraris without worrying about “socialist” principles.

As far as what happens next. American capitalism isn’t having a good run right now. The places that people are talking about using as a model for how to run an economy are Hong Kong and Singapore.

bystander

It seems to me that it doesn’t work to say that China’s economy doesn’t have such-and-such a problem because the U.S. has this-and-the-other problem. The two countries can both have very serious (and different) problems at the same time; there’s no contradiction. There’s also no possibility that China will adopt a system modeled closely on the U.S., so I don’t see what the point of the comparisons is. If China has a problem of snowballing debt caused by inefficient capital allocation, then it has that problem. It doesn’t help China any to point out that the U.S. had a housing bubble or has a huge fiscal debt or weird marketplace distortions of its own, it seems to me.
r_s_g

Joe Studwell in Asian Godfathers writes, “Hong Kong and Singapore were destined to succeed. All they had to do was to be one degree more efficient, one degree more attractive to capital than surrounding countries and they would prosper…A city state with a strategic deep water port in a region that has relatively higher levels of mismanagement, corruption and political uncertainty will prosper with little reference to official economic philosophy.”

Few countries are lucky enough to be be able use such locations as viable economic models.

bystander

Good post. As a fan of Michael Pettis’ writings, I’d tend to say that the biggest danger is not the ability to “price risk”, but rather the danger of making bad investment on a very big scale. At the end of the day, that must turn into unsustainable debt. Pricing risk is, you could say, the flipside of the same coin, but the real damage is done by inefficient use of capital (on a grand scale) and the saddling of the country’s banks with bad debt. The trick is to somehow change the balance so that the country’s capital is efficiently allocated and the constant transfer of money from the household sector to the state is halted and reversed.
Twofish

bystander: Good post. As a fan of Michael Pettis’ writings, I’d tend to say that
the biggest danger is not the ability to “price risk”, but rather the
danger of making bad investment on a very big scale.

The problem with this is view is that one can be so afraid of making bad investments that no investments are being made at all. The other problem is that an obsession with efficiency can cause massive misinvestment. If you define “efficiency” as the return in investment, then one increases “efficiency” by borrowing massive amounts of money, cutting reserves, and then making huge “heads I win, tails you lose” bets. What ends up happening is that when there is a crisis then everything falls apart. I would argue that one of the main reasons that China has avoided a financial crisis is that the banks and large SOE’s are extremely *inefficient*. They have large amounts of cash, which looks bad on a balance sheet, but can avoid a major crisis when things go bad.

bystander: The trick is to somehow change the balance so that the country’s capital
is efficiently allocated and the constant transfer of money from the
household sector to the state is halted and reversed.

Except that the transfer is in both directions. The reason the SOE’s were extremely unprofitable was that they were saddled with massive social welfare liabilities. Once the state took those over, the SOE’s could restructure and they are quite profitable now. The increase in savings over the last few years has been in the corporate sectors.

The same thing happened with General Motors.

One problem with some economists is that history has moved on. The problems of the late-1990′s have for the most part been fixed, leading to new problems. The problem now is not in the SOE’s, but rather in the local government investment funds which are part of the shadow banking system.

bystander: There’s also no possibility that China will adopt a system modeled
closely on the U.S., so I don’t see what the point of the comparisons
is.

Not true. You can adopt bits and pieces of other people’s systems. A lot of Chinese banking and corporate law is modelled after that of the United States, because the United States was the main model when some major decisions were made. For example, Chinese banks can’t own corporations, and you have a separation between investment and commercial banking. This is all copied from the US. No one wants to copy the US now, and the big model right now is Singapore.

bystander: If China has a problem of snowballing debt caused by inefficient
capital allocation, then it has that problem. It doesn’t help China any
to point out that the U.S. had a housing bubble or has a huge fiscal
debt or weird marketplace distortions of its own, it seems to me.

Except it’s quite possible that *isn’t* the problem in either the United States or China. In 2008, the Chinese government made the decision that the danger of inefficient capital allocation was much less serious than the danger of lack of aggregate demand. The US made the opposite decision. Part of the reason I think that China has done better over the last four years than the US is because of that decision.

Personally, I think that Michael Pettis has got it fundamentally wrong, and countries that take his advice (i.e. the US) will seriously regret it. What will happen is that the obsession with efficient capital allocation will kill any investment which means that over time, you get less and less productive and that causes a downward spiral.
Twofish

dan berg: Twofish apparently sees his role in this world as obfuscation; America also has SOEs, China also invests in US multinationals

It’s called pointing out how complex reality is. I get annoyed when people create cartoons of economies that in fact bears no little resemblance to how things really operate.

There is an interesting problem with SOE’s which creates a lot of circular reasoning. It’s not clear from a Chinese company, what is an SOE and what isn’t. What ends up happening is that people use the “smell test.” If it looks like an SOE, then it’s an SOE. However, if you have a company that could be classified as both, then if it looks good, we’ll call if private, and if it looks bad, then we’ll call it an SOE. Then once you’ve done that classification you can prove that SOE’s are naturally superior.

You see this a lot in looking at the Chinese economy. If you are in a “capitalism good, socialism bad” frame of mind, then everything good about the Chinese economy is “capitalist” and everything bad about it is “socialist.” The problem is that in looking at the world this way, it really tells you nothing about what’s going on.

Also, dividing the world into two groups doesn’t make sense. Knowing someone’s opinions on whether to crack down on dissidents tells me *nothing at all* about their opinions (if they have any) on the structure of Chinese banks and vice versa. The word “reform” in China is pretty meaningless. Everyone in China is “pro-reform” and being “pro-reform” tells me nothing about what they really believe.
Twofish

“Reform” is a meaningless term in Chinese politics. There are no groups that are willing to call themselves “anti-reform” and being called “anti-reform” is a label you try to pin on your political enemies. It’s like knowing being “pro-freedom” in the United States. Because everyone claims to be “pro-freedom” and no one claims to be “anti-freedom.” It’s a meaningless term, because it tells you nothing about what people believe.

More useful political terms are “liberal” and “leftist” since there are people in China that will claim to be pro-liberal or anti-liberal or pro-leftist and anti-leftist. So that get you the general ideological trends, but even there are surprises. A lot of Chinese politics (like politics everywhere else) is driven by interest groups and self-interest. Judges want more power and money for judges. Police want more power and money for police, etc. etc.
http://twitter.com/bucketoftongues Mike Cormack 王迈克

Very good article. It’s just what I have been coming to think and feel about the financial basics of China. I do not see how China can ever become a genuine superpower in this setup.

Financial Reform In China? Don’t Bet On It.

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