Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise
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Far surpassing the CDB and the localities were the PBOC’s efforts to sterilize the creation of new RMB generated by China’s huge inflows of foreign currency. From 2003, as China’s trade surplus began to widen and foreign investors flocked to invest, the PBOC began to issue ever-increasing amounts of short-term notes (and sometimes long-term notes, as we saw in Chapter 3) to control the domestic money supply. This use of a market-based tool to manage the macro-economy was a first in China, but pressures on the PBOC grew to the point that its institutional rival, the MOF, was able to step in and “help out.” A complex series of transactions relating to the establishment of China’s second sovereign-wealth fund revealed a triumphant MOF in control of the very lynchpin of the domestic financial system, once again bringing the story back to the bank dividend policies described earlier.
THE CDB, THE MOF AND THE BIG 4 BANKS
The rapid growth in the China Development Bank’s funding and lending activities coincides with the ascension of the new Party and government leadership in 2003 and the start of a continuing debate about China’s economic development model. During this time, the CDB became the darling of those supporting a return to both a more state-planned economy domestically and a natural-resource-based foreign policy internationally. But understanding the CDB’s position is complicated by the fact that, on the one hand, it represented a challenge to the prevailing banking model sponsored by Zhou while, on the other, it depended on the PBOC for approval of its annual bond-issuance plan. The dramatic increase in its bond issuance during this period may be the result of the PBOC’s antipathy toward the MOF; but the MOF also had its own tactics.
Chen Yuan, the bank’s very ambitious founding chairman, positioned the CDB deliberately as an alternative model to the Big 4 banks. The Big 4, under Zhou Xiaochuan’s reform program, followed a path modeled after their international counterparts, including the deliberate introduction of international banks as strategic investors. As we saw earlier, Chen Yuan was opposed to what he referred to as “that American stuff.” Instead, he proposed to “develop around our own needs and build our own banking system” which, he said, “must provide the capital to meet the needs of our high-growth economy, resolve the various financial bottlenecks of our enterprises and provide a channel for capital for various types of enterprise.”2
The bank’s investment projects, once included in the national budget, are now independent of it; the CDB can, to a certain extent, determine on its own “commercial” principles what projects to invest in and what not. Nonetheless, its projects are state projects and its obligations are state obligations. The CDB, unlike the Big 4 banks, was established as a ministerial-level entity with quasi-sovereign status reporting directly to the State Council. It is a typical example of an organization, not an institution, built around one man, the son of a powerful revolutionary-era personage. Chen’s father, Chen Yun, was the planner whose famous “Bird Cage” theory provided the ideological foundation for the Special Economic Zones in the 1980s. Political conservatives were able to accept the idea of foreign investment as long as it was “caged” inside these special zones. This powerful political concept has now morphed and provides the inspiration for the distinction between “inside” and “outside” the system. Unless there are bounds imposed by a determined Party leader, as was the case during Zhu Rongji’s era,3 “princelings” such as Chen Yuan can drive the political and economic process in ways contrary to the national interest, as we will see further in the next chapter. In Chen’s case, the goal has long been to add both an investment bank and a securities company to the CDB portfolio and become China’s first universal bank (and this in spite of his avowed aversion to “American stuff”). If the CDB can be a universal bank, is it any wonder that the Big 4 banks have reacted defensively by wanting to acquire the licenses held by their respective AMCs?
If it had succeeded, the strategy Chen marked out for the CDB would have marked a return of China’s banking system to the pre-reform era and the People’s Construction Bank of China (PCBC). Essentially a division of the MOF, the PCBC provided exactly the same kinds of long-term capital services for the economy as Chen’s CDB. The difference, however, is that the CDB possesses a modern corporate veneer and polished public-relations expertise, as evidenced by its website on which Chen’s old-fashioned sloganeering is pushed into the background. That, however, is not the most important difference. The PCBC was funded by the national budget and it channeled, on behalf of the MOF, the disbursement of interest-free investment funds to SOEs and special infrastructure projects contained in the state plan. But the CDB does not rely on the national budget for funding.
This fact and Chen’s own ambitions created a trap for the CDB. As a policy bank, the CDB funds itself through debt issuance in the markets, and China’s bond markets are fully reliant on the commercial banks and the PBOC for support. Some 72 percent of the CDB’s funding comes from those very banks Chen holds in such low esteem. As Figure 5.1 illustrates, beginning in 2005, CDB bond issues began to grow rapidly. This growth was approved by the PBOC, whose own position was being challenged by the MOF.
FIGURE 5.1 MOF vs. policy bank bond issuance, 2001–2009
Source: China Bond
Note: 2007 MOF issuance excludes the CIC Special Bond of RMB 1.55 trillion; 2009 MOF issuance excludes RMB200 billion local government bonds.
Since banks are the source of all funds, if this situation had continued, market saturation could have been reached and, from that point, the CDB would have begun to squeeze out the MOF, as Figure 5.1 indicates. Can one man fight the MOF as well as the Big 4 Banks? The answer is “No” and this is where ambition led Chen Yuan astray.
In addition to pursuing greater business scale, Chen appears to have envied the superficial modernity of the commercial banks. This led him to seek to create China’s first universal bank and to become publicly listed. He was clearly encouraged to pursue this goal and on December 11, 2008, the CDB became a joint-stock corporation, the first step in preparing for an IPO. But why in the world would the State Council seek to make a policy bank—which had been designed to make and hold non-commercial investments in state-designated infrastructure projects—into a commercial entity and then to list it? Chen’s argument was that “commercialization” would not change the bank’s strategy as a development bank:
The lesson we can take is that a first-class bank should not take even the very best Western bank as a standard. We should have an objective international standard . . . expressed as having high-quality assets, the trust of market investors, and an objective, fair and deep understanding of society’s needs and to work to resolve those social needs in order to receive society’s approval.4
The CDB model, with its emphasis on social-justice issues, threatens the last 15 years of profit-oriented banking reform in China and has already erased the policy-bank reforms of 1994. While Chen’s words and vision may have resonated among the country’s people and top leadership in the wake of the global financial crisis, they found no such resonance in the bond market.5 The reason for this is simple: the banking regulator had been less than precise in defining the CDB’s new status. After its incorporation, is the CDB still a semi-sovereign policy bank or is it now a commercial bank? From this definition flows the valuation of its outstanding bonds, as well as the pricing for future bond issues. Market pricing will differ depending on the answer and there is as yet no clear answer. It is not just about pricing: if the CDB is a commercial entity, other banks and insurance companies will only be able to invest up to a regulation-imposed limit and the CDB’s days of cheaply funded expansion will rapidly come to an end.
The uncertainty as to the CDB’s exact status is what accounts for its bonds being more actively traded than those of the MOF. Uncertainty is risk and the risk created by Chen’s ambition is by no means small for his investors, the commercial banks. They currently hold an estimated RMB3.2 trillion (US$460 billion) of his old bonds on their balance sheets and even a small 0.5 pe
rcent drop in value for them would mean mark-to-market losses of RMB16 billion (US$2.3 billion). Even though they hold CDB debt as investments, the loss of value on such a scale might ultimately require their international auditors to recommend loss provisions and a hit to their income.
In early 2010 as the party reflected on the massive lending binge of 2009, the accepted line became: “We know these projects do not produce cash flow today, but they will prove very useful to China’s development later on.” This describes perfectly the function of lending by policy banks. On the other hand, policy loans in commercial banks are, by definition, NPLs. This was recognized in 1994 when the CDB was established and the Big 4 banks embarked on commercialization. It is now beyond irony that just as China’s hard-built commercial banks have turned themselves into policy banks, the China Development Bank is striding in the opposite direction.
Without question, this market-based outcome has marked a defeat for Chen Yuan’s ambitions for the CDB and represents a major victory for the MOF, which in all probability encouraged his listing ambitions. As discussed below, when China Investment Corporation (CIC) acquired Central Huijin in 2007, it acquired a full 100 percent interest in the CDB. The tables were now turned on Chen Yuan. In the greatest of political ironies, the CDB has now returned to its roots—as a mere sub-department of the MOF—but at what cost to the system?
The People’s Bank of China and the National Development and Reform Commission
In contrast to the CDB’s aspirations and the MOF’s bloodless revenge, the now discredited market-oriented model espoused by reformers is far less eloquently described.6 It involved the development of direct, market-based, enterprise-financing capabilities based on the decisions of enterprise management. In other words, corporations were to be given a choice between banks and debt markets. Not only that, they were to take responsibility for their decisions for both shareholders and bond investors; in short, the full international capital-markets model. To create this possibility, in 2005, in the midst of collapsed domestic stock markets, the PBOC leveraged a regulatory loop hole defining “corporate bonds”7 as those with maturities above one year. It used this definition to create a short-term debt product, commercial paper (CP; duanqi rongziquan ), that quickly became the debt product of choice among SOEs.
In 1993, the PBOC had ceded the corporate-debt product to the State Planning Commission (SPC) primarily because issuers would not take responsibility for repayment of bonds on maturity. This created huge difficulties at the time and largely caused the product to be terminated. But in 2005, corporate bonds were a hot product again due to both bank reform and the weak equity markets. Unfortunately, the “enterprise bond” (qiyezhai ) market belonged to the SPC’s grandchild, the National Development and Reform Commission (NDRC), with underwriting done only by securities companies regulated by the CSRC. As the volume of issuance in the years up to 2005 illustrate (see Figure 5.2), neither agency gave much thought to developing this product. From the NDRC’s perspective, a bond was an afterthought. The few projects contained in its planning documents were funded by the national or local budgets or the banks and it could see no need to develop the bond product. From the CSRC’s perspective, bonds represented a zero-sum game with equity products, and the regulator’s avenue to achievement was not fixed-income products or markets.
FIGURE 5.2 Issue volume by product type,1992–2009
Source: PBOC, Financial Stability Report, various
Note: 2007 CGB issuance excludes the RMB1.55 trillion Special Bond
Zhou Xiaochuan provided a detailed analysis of the corporate market’s resultant inadequacies in his famous October 2005 speech excerpted at the start of this chapter.8 He rightly pointed out that the root cause of the market’s failure to develop was found in the command-economy mentality of the “early days of the transition when the economy was more planned than market-driven.” This comment, historically couched as it was, pointed straight at the NDRC, but the fact is that previous central bank administrations had also done little to promote the bond markets, leaving them to the MOF.
With the support of the Party’s “Nine Articles,” which explicitly called for the development of bond markets, the PBOC drove through this “one year and above” loop hole and created a CP market out of thin air. In 2005, its first year, more than RMB142 billion (US$17 billion) in CP was issued by presumably capital-starved SOEs. This amount tripled in 2008, with growth being driven by a unique ease of issuance: no regulatory approvals were required, only registration. PBOC reformers modeled this process after that used in the US wherein issuers are required to have a credit rating (this takes about three weeks in China), an underwriter (banks, which are not regulated by the CSRC), a prospectus, and a filing with the PBOC. To further ease the government out of any role in the market, in September 2007, the PBOC sponsored the establishment of an industry association—the National Association of Financial Markets Institutional Investors (NAFMII)—to manage things. In contrast to the opaqueness of China’s equity markets, the universe of debt issuers, their financials, approval documents and prospectuses are available for all to see online on the China Bond website.
NAFMII is registered as a non-profit, non-government organization authorized by the PBOC to advise on the development of the debt-capital market, to sponsor new policies and regulations, and to review debt issues. When establishing NAFMII, the PBOC was astute enough to create a governing board including the Who’s Who of China’s banking industry. In its brief existence, the agency has become the regulator in charge of the most rapidly growing segments of the inter-bank debt market, including local-currency risk-management products. Its scope of authority would, of course, exclude the NDRC’s enterprise bonds (qiyezhai ), as well as financial bonds and subordinated bank debt which, given their direct impact on the sensitive banking sector, remain directly with the PBOC.
If the commercial paper ploy did not upset the NDRC, the PBOC’s next move did. In April 2008, the PBOC, working through NAFMII, created a three–to–five-year medium-term note (zhongqi piaoju ). Unlike bonds, which are issued once and remain outstanding until redemption or maturity, MTNs are issued like CP as part of a “program” that allows the issuer, depending on his funding needs, to issue more or less of the securities within a certain overall limit. Perhaps a bit sarcastically, the NAFMII called these securities “non-financial enterprise financing instruments” (feijinrong qiye rongzi gongju ) in order to clearly demarcate them from the NDRC’s “enterprise” bonds and the CSRC’s “company” bonds. MTNs, like CP, only require registration with NAFMII.
The NDRC, however, did not find the wordplay funny and sought to stop the PBOC and its MTNs by claiming control over the notes which, after all, had tenors of more than one year. The State Council accepted the case, delaying the product’s debut for four months. Later in the year, however, a consensus developed that more debt in the right hands would bolster the swooning stock markets and MTNs were given the go-ahead. In just three months, enterprises raised RMB174 billion (US$26 billion), in new capital and, in 2009, the market grew explosively. By year-end, some RMB608 billion(US$ 89 billion) in new MTNs had been issued. Together with CP, these new instruments accounted for 22 percent of the total capital raised in the fixed-income markets in 2009.
With the defeat of its approach to financial reform in 2005, the PBOC could only push the development of new products in its own space as part of the infrastructure for the future. As Figure 4.10 shows, CP and MTNs with their shorter maturities brought in new non-state investors, mutual funds and foreign banks. For the first time in China’s bond markets, such investors played a significant role, accounting for 30 percent of short-term corporate-debt holdings. Such small victories can, over time, add up to something important when circumstances change.
LOCAL GOVERNMENTS UNLEASHED
The PBOC’s product innovations provided a solution to financing problems for all sorts of Chinese corporations and not just those commonly thought of as SOEs. It has be
en 15 years since the last serious reform of China’s system of taxation created a clear split between those taxes belonging to the center and those to the localities. Since that time, SOE reform, the closures of hundreds of failed local financial institutions and the centralization of bank management have greatly reduced the financial resources available to local governments. The shortfall between revenues and expenditures has widened significantly.
In its 2009 budget report to the National People’s Congress (NPC), the MOF confirmed that, overall, local governments ran major fiscal deficits. The report stated that total local revenues amounted to RMB5.9 trillion (US$865 billion), of which RMB2.89 trillion (US$423 billion) derived from tax-transfer payments from the central government. Set against this, local-government expenditures were RMB6.13 trillion (US$900 billion). The life of a provincial governor or city mayor is dominated by a scramble to raise capital in support of local development and new jobs. Previously, SOE reform—selling off poorly performing SOEs outright or listing the shares of good ones—and attracting large amounts of foreign investment had shown the way forward for the most commercially sophisticated provinces. But there are few provinces that share the commercial attractions of China’s coastal areas. There are only so many SOEs that can be publicly listed, even on supportive Chinese exchanges. After the Asian Financial Crisis, the poorly performing SOEs had been privatized or closed entirely to preserve local resources. As a result, to increase their budgets and service their debt, local governments rely on cash flow from projects and land auctions, which reportedly contribute over one-third of local extra-budgetary revenue.