By: Steve Dickinson
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?