Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise

by Carl E. Walter; Fraser J. T. Howie

  How, then, can the Party allow the banks to be disintermediated by capital markets or real outside competition? Protectionist measures, controlled exchange rates and fixed lending spreads ensure the Party’s control and the stability of the system, and virtually guarantee that the banks must raise new capital every few years to prime the cycle. Viewed from the outside, bank profits reassure retail depositors that their banks are sound and their deposits safe. International investors support bank shares since they are seen as proxies of a bank-driven GDP number. The banks use household deposits and new equity capital to fund new loans to drive GDP and to support the conceit that is China’s debt-capital market, which sustains the appearance of overall convergence toward a Western-style market system.

  Instead of removing the risk burden from the banks, China’s backward bond markets create new risk. Making up around 30 percent of the total assets of the Big 4 banks, these “investment” portfolios enjoy negative interest spreads, leaving the banks exposed to significant market risk. In order to offset this weight, banks will inevitably lend more and increase credit risk. More asset bubbles, stock-market booms and problem loans are the inevitable product of this arrangement. The tools to deal with these problems, the AMCs, the MOF’s IOUs and the PBOC’s credit support, already exist. As has been shown with the first generation of bad loans, these measures have contained the problem and pushed the inevitable off into the future onto the agenda of the next Party leadership group and out of the memory of international observers. The cycles and the pressures that are building up “inside the system” can continue for a very long time. Where is the catalyst that will disrupt it? Even if the Emperor is ultimately seen to be naked, he is still the Emperor.

  ENDNOTES

  1 The Economic Observer , January 11, 2010: 1.

  2 The Economic Observer , July 20, 2009: 41.

  3 Zhu thwarted Chen’s first attempt in 1995 to establish an investment bank in favor of Wang Qishan’s joint venture with Morgan Stanley, CICC.

  4 The Economic Observer , July 20, 2008: 41.

  5 The Economic Observer , January 11, 2010: 1.

  6 See Li Liming, “Liangnian zhongguo jinrong shengtai gaibianle , (In two years China’s financial environment has changed),” The Economic Observer , August 29, 2005: 10. This failed effort at reform in 2005 was picked up again in the major article by Yang Kaisheng, ICBC’s CEO, in early 2010, “Wending woguo shangye yinhang ziben chongzu shuiping de jidian sikao (Several thoughts on stabilizing the capital adequacy levels of our country’s commercial banks,” 21st Century Business Herald 21, April 13, 2010: 10.

  7 It is confusing to translate “corporate bonds,” as there are two types: one controlled by the NDRC and traded in the inter-bank market (qiyezhai ), and one controlled by the CSRC and traded on the stock exchanges (gongsizhai ). Zhou’s loophole related to the NDRC regulations.

  8 Zhou Xiaochuan, “Learn lessons from the past for the benefit of future endeavor,” Speech at the China Bond Market Development Summit, Beijing, October 20, 2005, www.pbc.gov.cn/english/detail.asp?col=6500&ID=82

  9 See Fang Huilei, Zhang Man, Yu Jing and Zhang Yuzhe, “Scary View from China’s Financing Platforms,”Caixin Magazine online, February 5, 2010; and Victor Shih, “Big rock-candy mountain,” China Economic Quarterly 14(2), June 2010.

  10 21st Century Business Herald 21, April 12, 2010: 6.

  11 There is a second interesting attraction to using a bond and interest payments to channel money to the MOF: payment would not require any involvement of CIC’s board of directors, it would simply be business as usual. As the cash flow came in as dividends from its subsidiary banks, CIC’s CFO would simply pay interest when due to the MOF; no formal board decisions or minutes would need to be made. Contrast this with the SASAC.

  12 Huijin paid US$22.5 billion each for BOC and CCB and US$15 billion for the ICBC, and US$7 billion for interests in a variety of securities companies. It carries these investments on its books at this same value, notwithstanding that the banks have all been listed and have a market value far above this number.

  13 First rumored in November 2009 and then confirmed in April 2010. See Bloomberg, November 11, 2009; and Caixin , April 23, 2010; Asian Investor, April 1, 2010.

  14 This refers to the PBOC, the CSRC, the CBRC, and the China Insurance Regulatory Commission. For the background, see The Economic Observer , July 12, 2010: 2.

  CHAPTER 6

  Western Finance, SOE Reform and China’s Stock Markets

  “The debut price [of my IPO] was within expectations, but I am still a wee bit disappointed.”

  Chen Biting, Chairman, China Shenhua Energy

  October 10, 2007

  In capital-raising terms, China’s stock markets pale in comparison to the bank loan and bond markets, but they have been instrumental in creating the country’s companies and, at the same time, lending China the veneer of a modern capitalist economy. Without them, China would have remained for an even longer time without a truly national market for capital. More importantly, its ministries would not have learned at the knee of Goldman Sachs and Morgan Stanley how to use international corporate law and complex transfers of equity shares to build the National Team, a group of state-controlled enterprises of an economic scale never before seen in China. When in 2006 and 2007 these companies began to return home to the Shanghai market for secondary listings, they were able to use their great wealth to reward “friends and family”, those other state enterprises and agencies closely associated with the Party and allowed to take profit from the listing as investors.

  This explains the comment by Shenhua’s chairman: his company’s “poor” IPO performance was, perhaps, a disappointment to his supporters. In these listings, company valuations deliberately set too low, biased lottery allocations1 and the channeling of money among powerful state entities is clearly documented for all to see. It raises the question, however, of whether China is run, as people believe, by the Communist Party or whether the National Team has subsumed the Party and the government so that it can truly be said that “the business of China is business”. China’s stock markets are not really about money (that comes from the banks): they are about power.

  CHINA’S STOCK MARKETS TODAY

  On October 7, 1992, a small company that manufactured minibuses completed its IPO on the New York Stock Exchange (NYSE), raising $80 million. This would hardly have been a landmark event except that the company was Chinese and no Chinese company had ever listed its shares outside the country, much less on the NYSE.2 Wildly oversubscribed, Brilliance China Automotive singlehandedly put China—and most certainly not the People’s Republic of China—on the map of global capital. Since that time, the clamor surrounding China’s stock markets makes it seem that New York and London have long since been eclipsed as the world’s most significant markets for equity capital.

  On their surface, China’s stock markets are the biggest in Asia, with many of the world’s largest companies, and more than 120 million separate accounts trading stocks in nearly 1,800 companies. Their capital-raising abilities are the stuff of legend (see Table 6.1). According to data from Bloomberg, since January 2006, half of the world’s top 10 IPOs were Chinese companies raising over US$45 billion. It is not uncommon for new issues in Shanghai to be 500 times oversubscribed, with more than US$400 billion pledged for a single offering. The scale of China’s companies since 1990 has increased exponentially. In 1996 the total market capitalization of the top 10 listed companies in Shanghai was US$17.9 billion; by year-end 1999, this was US$25.3 billion and, 10 years later, US$1.063 trillion! Like everything else about China, the simple scale of these offerings and the growth they represent at times seems staggering.

  TABLE 6.1 Funds raised by Chinese companies, China and Hong Kong markets

  Source: Wind Information and Hong Kong Stock Exchange to September 30, 2010

  Note: US$ at prevailing rates; Hong Kong GEM listings not included; No B-share issuance since 2000.

  Of co
urse, the scale of the profit involved can also be huge. In 2009, Chinese companies raised some US$100 billion, of which 75 percent was completed in their domestic markets of Shanghai and Shenzhen. Underwriting fees in China are around two percent, suggesting that China’s investment banks (and only the top 10 at best participate in this lucrative business) earned fees totaling US$1.5 billion. This amount, as large as it, pales in comparison to the amount collected in brokerage fees. For example, on a single day, November 27, 2009, A-share trading on the Shanghai and Shenzhen markets reached a historic high of over RMB485 billion (US$70 billion) in value. For a market that doesn’t allow intra-day trading, that turnover is truly impressive—more than double the rest of Asia, including Japan, combined. Brokerage fees for that one day alone totaled around US$210 million, spread between 103 securities companies. With all that money up for grabs (and a clear preference for domestic over foreign markets by Chinese companies) it is no wonder that there is so much noise surrounding China’s stock markets—investment bankers anywhere are hardly known for being self-effacing and China’s are no different.

  Observers are also very impressed with the market’s infrastructure. Like the inter-bank debt markets, the mechanics of the stock exchanges are state-of-the-art, with fully electronic trading platforms, efficient settlement and clearing systems and all the obvious metrics such as indices, disclosure, real-time price dissemination and corporate notices. The range of information provided on exchange websites is also impressive and completely accurate, but all of this is only a part of the picture. China’s stock exchanges are not founded on the concept of private companies or private property; they are based solely on the interests of the Party. Consequently, despite the infrastructure, the data and all the money raised, China’s stock markets are a triumph of form over substance. They give the country’s economy the look of modernity, but like the debt-capital markets, the reality is they have failed to develop as a genuine market for the ownership of companies.

  The engine at the heart of the debt markets is the valuation of risk and this is missing in China because the Party controls interest rates. Similarly, the heart of a stock market is the valuation of companies and this is also missing in China because the Party controls the ownership of listed companies. Private property is not the central organizing concept of the Chinese economy; rather, the central organizing concept is tied to control and ownership by the Communist Party. Given this basic premise, markets cannot be used as the means to allocate scarce resources and drive economic development. This role belongs to the Party which, to achieve its own ends, actively manipulates both the stock and debt markets. As shown in the previous two chapters, the debt market cycle takes place within a regime of controlled interest rates and suppressed risk valuations that are the corollary to the Party’s control over the allocation of capital. The stock markets, in contrast, are vibrant, but do not trade securities that convey an ownership interest in companies. What these securities do represent is unclear, other than that they have a speculative quality that permits gains and losses from trading and IPOs.

  In China, the stock and the real-estate markets have evolved into controlled outlets for surplus capital seeking a real return and, for the most part, this capital is controlled by agencies of the state. Stocks and real estate are the only two arenas in China that, although subject to frequent administrative interference, can produce rates of return greater than inflation. The huge run-up in the Shanghai Index in 2007 is an example of this (see Figure 6.1): the significant appreciation of the RMB that year drew in large volumes of “hot money” that was then parked in stocks, drawing the index ever higher. Like developed markets, China’s stock markets operate rationally, but only within a framework shaped by the distorted and biased initial conditions set by the state. Their substance cannot and will not change unless these boundary conditions change. This would require outright and publicly accepted privatization—a highly unlikely prospect in any prognosticator’s near- or medium-term futures.

  FIGURE 6.1 Performance of the Shanghai Index, 1999–2009

  Source: Wind Information

  WHY DOES CHINA HAVE STOCK MARKETS?

  Why would China’s government in 1990 of all times decide to create stock markets? The decision to open the Shanghai exchange was made in June 1990, just a year after Tiananmen, and it opened at year-end in the midst of malicious political mudslinging concerning whether the reforms of the 1980s belonged to what are commonly referred to in China as “Mr. Capitalism” or “Mr. Socialism.” The markets were not needed from the viewpoint of capital allocation. Then, as now, the Big 4 banks provided all the funds the state-owned sector could possibly want. The reason for establishing stock markets was not related to political expediency or the capital requirements of SOEs. Rather, Beijing decided to establish stock markets in 1990 largely from an urge to control sources of social unrest and, in part, because of the inability of its SOEs to operate efficiently and competitively. The stock-market solution to both issues was purely fortuitous. If there had not been a small group of people sponsored by Zhu Rongji who had plans for stock markets already drawn up, China today could have been quite different. Moreover, had these people retained authority over market development into the new century, China could have been quite different in yet another way.

  “Share fever” and social “unrest”

  In the 1980s, China’s stock markets arose for the same reasons as stock markets in Western private economies: small, private and state-owned companies were starved of capital and small household investors were seeking a return. The idea of using shares to raise money sprang up simultaneously in many parts of the country and, given the relaxed political atmosphere of the times, the ideas were allowed to take shape.3 Despite Shanghai’s raucous claims to be the country’s financial center, there is no argument but that Shenzhen was the catalyst to all that has come after. Its proximity and cultural similarity to Hong Kong were major factors behind this. The key year was 1987, when five Shenzhen SOEs offered shares to the public. Shenzhen Development Bank (SDB), China’s first financial institution (and first major SOE) limited by shares, led off in May and was followed in December by Vanke, now a leading property developer. Their IPOs were undersubscribed and drew no interest. The retail public’s indifference to SDB’s IPO even forced the Party organization in Shenzhen to mobilize its members to buy shares. Despite this support, only 50 percent of its issue was subscribed.

  The fact is that after more than 30 years of central planning, near-civil war and state ownership, the understanding of what exactly an equity share was had been lost in the mists of pre-revolution history. Where securities called “shares” existed, investors thought of them as valuable only for the “dividends” paid; people bought them to hold for the cash flow. There was no awareness that shares might appreciate (or depreciate) in value, and so yield up a capital gain (or loss). So the market was understandably tepid for the bank’s IPO and it was also unprepared for events that followed payment of the first dividend in early 1989.

  The SDB’s dividend announcement in early 1989 marked a major turning point in China’s economic history and it should be recognized as such. The bank was very generous, awarding its shareholders—largely state and Party investors—a cash dividend of RMB10 per share and a two-for-one stock dividend. In the blink of an eye, those who had bought the bank’s shares in 1988 for about RMB20 enjoyed a profit several times their original investment. Even so, a small number of shareholders failed to claim their stock dividends and the bank followed procedures to auction them off publicly. The story goes that when one individual suddenly appeared at the auction, offered RMB120 per share, and bought the whole lot, people got the point: shares were worth something more than simple face value. As this news spread in Shenzhen, a fire began to blaze. The bank’s shares, as well as the few other stocks available, sky rocketed in wild street trading. SDB’s shares jumped from a year-end price of RMB40 to RMB120 just before June 4, 1989, and despite the political troubl
e up north, ended the year at RMB90.

  Armed with this new insight, China’s retail investors set off a period of “share fever” centering on Shenzhen and gradually extending to Shanghai and other cities such as Chengdu, Wuhan and Shenyang where shares were traded. In the end, Beijing forced local governments to take steps to cool things down. Restrictions eventually took hold, leading to a market collapse in late 1990. Even so, investors had learned the lesson of equity investing: stocks can appreciate. But Beijing had also learned a lesson: stock trading could lead to social unrest. The decision to establish formal stock exchanges was made in the midst of “share fever” in June 1990 and the Shenzhen and Shanghai exchanges opened later the same year.

  State-owned enterprise reform via incorporation

  Of course, Beijing could simply have forbidden stocks and all associated activity, but it didn’t. The reason for this can be found in a policy debate about the sources of dismal SOE performance. Despite the government’s lavishing of resources and special policies of all kinds on SOEs during the 1980s, China’s emerging private sector had left them in the dust.