IMPORTANT DISCLAIMER:

THE FOLLOWING PRESENTATION REPRESENTS MY PERSONAL OPINIONS

AND DOES NOT REPRESENT A COMPRHENSIVE ANALYSIS OF THE
CHINESE ECONOMY. ALTHOUGH THE INFORMATION CONTAINED HAS
BEEN OBTAINED FROM SOURCES BELIEVED TO BE ACCURATE I CANNOT
GUARANTEE ITS ACCURACY, COMPLETENESS, OR FAIRNESS. OPINIONS
INVOLVE NUMEROUS ASSUMPTIONS WHICH MAY OR MAY NOT PROVE
VALID AND WHICH MAY BE CHANGED WITHOUT NOTICE.
THIS PRESENTATION IS INTENDED FOR INFORMATION PURPOSES ONLY
AND DOES NOT CONSTITUE INVESTMENT ADVICE, A RECOMMENDATION,
SOLICITATION, OR OFFER AND IS NOT THE BASIS FOR ANY CONTRACT TO
PURCHASE OR SELL ANY SECURITY OR OTHER INSTRUMENT.
I, AS WELL AS PERSONS ASSOCIATED WITH MYSELF, MAY MAINTAIN
POSITIONS IN SECURITIES, INSTRUMENTS, AND/OR MARKETS REFERRED
TO BY THIS PRESENTATION.
Questions, comments, and all other inquiries should be directed to
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Nacioeconomic Review
uiowth Biiveis
Nonetaiy Policy & the Cuiiency
Social Implications
Banking & Finance
Coipoiate Finance
Regulatoiy & Naiket Stiuctuie
Paity & State
0veiview of Political System
A Biief Bistoiy of Refoim
Inuustiy & the State
Stiuctuial vulneiabilities
Summaiy & Conclusion
Ren Xiong (18231857)
LateQingdynastypainterofthe
Shanghaischool
I. Nacioeconomic Review
Since iefoim began in 1978, China has
achieveu spectaculai giowth:
9.8% annual giowth since 1978
Woilus 2
nu
laigest economy in 2u1u
Woilus 18
th
laigest economy in 1978
INF pieuicts:
China uBP > 0SA uBP by 2u16 (PPP)
Notable uiveigence fiom uevelopeu
woilu in 2uu82uu9
Consensus view
uiauualist school
China is inciementally conveiging with
Westein economic anu political noims
China will oveitake the 0S as global
consumei anu economic leauei
In billions of USD
Source: IMF
GDP
Chinas giowth iecoiu is impiessive, even when compaieu to othei
emeiging maikets:
0
2000
4000
6000
8000
10000
12000
14000
16000
1980 1985 1990 1995 2000 2005
China
US
Euro Area
Canada
Japan
India
Brazil
Korea
Indonesia
Malaysia
Bow has this been achieveu so quickly.
Source: IMF
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
ChinasShareofWorldGDP 19782010
HowhasChinagonefrombeinganeconomicbackwaterto
threateningAmericansupremacyinjust30years?

Bow uoes China manage this seemingly impossible balance.

Weaddresseachofthesepointsinturnbeforereviewing
Chinasfinancialandpoliticaleconomy:
Naintain weak ienminbi (RNB)
to pieseive expoit competitiveness
Restiain inflation
Achieve consistent giowth
78% explicit taiget
Chinese macioeconomic policy attempts to
balance:
Open capital account
Necessitateu by ieliance on tiaue
Poious capital contiols
0pen to foieign uiiect investment (FBI) with
limiteu poitfolio flows
Fixed exchange iate
Nanageu peg to 0SB
Independent monetaiy policy
Theoiy suggests this is impossible
1,2,S
The Impossible Tiinity
This balance has been achieveu by the states
coeicive powei anu its uominance of uomestic
maikets
1 R.A.Mundell,CapitalMobilityandStabilizationPolicyunderFixedandFlexibleExchangeRates,CanadianJournalofEconomics&PoliticalScience29(1963)
2 M.J.Fleming,DomesticFinancialPoliciesunderFixedandFloatingExchangeRates,InternationalMonetaryFundStaffPapers 9(1962)
3 A.Rose,ExchangeRateVolatility,MonetaryPolicy,andCapitalMobility:EmpiricalEvidenceontheHolyTrinity,NBERWorkingPaper 4630(1994)
Baving Youi Cake
Expoits subsiuizeu by cential bank, the Peoples Bank of China (PB0C)
Nonetaiy authoiity, acts in bioauly similai fashion to uevelopeu
maiket cential banks
Noimally, Chinas peisistent tiaue suiplus woulu cause the ienminbi
(RNB) to stiengthen against the uollai (0SB):
The PB0C pievents the tiaue balance fiom aujusting by
inteivening in FX maikets to maintain the weak RNB
Piints RNB to buy uollais in open maiket opeiations
Tiansacteu as much as $1.8 bnuay in 2uu7!
1
Inheiently inflationaiy; impact must be compensateu foi
Impact steiilizeu by iemoving cuiiency fiom ciiculation
97uS China foimally peggeu
RNB against 0SB
uSu8 Nanageu float allows
foi ~2u% appieciation
u8 Piesent Befacto 0SB peg
~6.8u RNB0SB global
slowuown calls foi halt to
appieciation
A Biief Bistoiy of
Chinese Cuiiency
Nanipulation
1 J.Greenwood.TheCostsandImplicationsofPBOCSterilization,CatoJournal Vol.28,No.2(2008)
Steiilization causes significant local anu
inteinational economic uistoitions
Sterilizationcanonlypostponeinevitable
adjustments
anu Eating It Too
The mechanics of steiilization:
Chinese expoiteis ieceive 0SB fiom Ameiican buyeis
Expoiteis sell 0SB to PB0C
Expoitei ieceives newly cieateu RNB fiom
Piinting RNB offsets natuial aujustment
PB0C accumulates 0SB ieseives, RNB supply l
Newlypiinteu RNB must be steiilizeu:
0SB useu to puichase foieign assets:
Laigely paikeu in 0S Tieasuiies
No sufficiently laigeliquiu alteinatives
Reseives ueployeu incieasingly aggiessively via
soveieign wealth funus etc.
Asset puichases augmenteu by financial iepiession:
Necessaiy to minimize leveiageu effect of RNB
cieation thiough fiactional ieseive banking
A Biief Bistoiy of Chinese
Cuiiency Nanipulation
Fiee fiom the iule of law, China has useu financial
iepiession to limit the inflationaiy impact of
peipetual money piinting:
PB0C sets ueposit anu lenuing iates aitificially
PB0C imposes lenuing quotas on banks
PB0C issues ST notes anu Special Bills to banks
Low yieluing bonus foiceu upon banks to immobilize
bank assets below maiket coupons
Be facto inciease of bank ieseive iequiiements
S.1% of uomestic assets at 12S11u
1
Bank ieseive iequiiements
2S.S% of uomestic assets at 12S11u
2
~30%ofbankcapitalimmobilized
Inflationaiy piessuies continue nonetheless
1,2 PBOC2010AnnualReport,ChinaBankingRegulatoryCommission
Chinahasmadecappingpricerisesthepriorityofmacroeconomicregulationandintroducedahostof
targetedpolicies.Thesehaveworked.Weareconfidentpriceriseswillbefirmlyundercontrolthisyear.
Wen }iabao (), 62S11 Financial Times euitoiial
0fficial figuies unueistate tiue maiket iates anecuotal eviuence of iates in shauow banking
system >2u% in 2u11
Source: PBOC, Bloomberg, China Economic Information Network
-15%
-10%
-5%
0%
5%
10%
15%
20%
1/1/2007 1/1/2008 1/1/2009 1/1/2010 1/1/2011
SHIBOR 3
Mo.
Deposit
Rate 3 Mo.
CPI, YoY
PPI, YoY
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
0.0
2,000.0
4,000.0
6,000.0
8,000.0
10,000.0
12,000.0
14,000.0
US M2
China M2,
USD
US YoY
China YoY
0S & Chinese Nonetaiy Aggiegates
A sight to humble even Belicoptei Ben
Source: Federal Reserve, PBOC
Massivefiscalstimulus 14%ofGDP!(USstimulus 6%)
The PB0Cs peipetual money piinting calls into question uemanubaseu estimates of the value
of Chinese cuiiency ChinahasagreatermoneystockthantheUS
Explicit costs of steiilization:
Spieau between costs of special bills anu ietuin on
foieign assets
Size of special bills ielative to size of foieign assets
1 PBOCStatistics&Figures2010
Implicit costs of steiilization:
Lenuing shifts to shauow banking system
0ff balance sheet leveiage anu
unueigiounu banking system
Bistoits capital allocation
PB0C balance sheet expansion ciowus out
consumption
Balance sheet must giow with economy to
maintain peg
12S11u PB0C is leveieu 1,180x!
1
Inflation can only be suppiesseu tempoiaiily:
Liquiuity oveihang iemains on PB0C
balance sheet
Significant obstacle to ueploying ieseives
uomestically
0ltimate aujustment filteis thiough via:
Bomestic piices
Expoit sectoi via iesouice piocuiement
Significant buyei of commouities
0
500
1,000
1,500
2,000
2,500
3,000
3,500
12/1/1999 12/1/2001 12/1/2003 12/1/2005 12/1/2007 12/1/2009
Billions of USD
Source: China Economic Information Network, Bloomberg
ForeignExchangeReserves 19992011
CurrentPBOCGovernorZhouXiaochuan ()
At 6S111 Chinas ieseives weie:
3.4x2005reserves
17.7x2001reserves
Raising inteiest iates last iesoit foi PB0C to contiol inflation:
Raises costs of cuiiency steiilization ueposit iate +1% = costs +~S%
1
Attiacts speculative capital flows (hot money)
Inflicts losses on banking sectoi via bonu holuings
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
Household
Savings
Deposits 1
Yr. Rate
China 1 Yr.
Lending
Rate
Deposit
Reserve
Ratio
1 Christer Ljungwall,Christer,YiXiong,andZou Yutong.CentralBankFinancialStrengthandtheCostofSterilizationinChina.CERCWorkingPaper8(2009)
Source: PBOC, Bloomberg
Neicantilist tiaue policysteiilization has leu China to shaie }apans buiuen of
unueiwiiting Ameiican piofligacy China is a foiceu buyei:
Source: US Treasury, billions of USD
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
45.0%
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
US Debt, Held by
Foreigners
US Debt to China
US Debt to
Japan
China, % of Tot.
Japan, % of Tot.
China is ~1u% of Woilu uBP but its shaie of global commouity consumption is
much highei:
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
Cement Iron Ore Coal Steel Lead Zinc Alumninum Copper Nickel Pork Eggs Rice Soybeans
Source: GMO, 4/11 Quarterly Letter
Chinas iesouiceintensive giowth is stietching global supply
Fuithei giowth will piove incieasingly costly anu piessuie uomestic piices
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
1978 1981 1984 1987 1990 1993 1996
CPI, YoY
CPI, Urban, YoY
CPI, Rural, YoY
Pievious inflationaiy suiges (late 8us, miu 9us) manageu by extiaoiuinaiy financial
iepiession
Total halt of bank lenuing, sweeping centialization of financefiscal authoiity, etc.
Achieveu by poweiful coie leaueis (i.e. Beng Xiaoping, Zhu Rhongji, etc.)
0ncleai if cuiient buieauciatizeu appaiatus is capable of iepeating such uiastic action
Source: PBOC, Bloomberg
ChineseConsumerPriceIndices 19781998
Like Asian peeis, China has utilizeu the expoit
giowth mouel:
Aibitiage auvantage fiom low cost laboi
2uSS%uBP fiom expoits
0ltimate impact is laigei:
Pioceeus aie leveieu thiough state
financial system & ieinvesteu
uomestically
4uSu% of uBP fiom fixeu asset
investment
Piimaiy uestinations foi fixeu asset
investment
1
:
Expoit piouuction capacity
Real estate
Significant leveiage to global uemanu
Investment incieasingly compensating foi weak
global uemanu:
~7u% of 2uu8 giowth
~9u% of 2uu9 giowth
2
1 MoodysAnalyticsReportChina:FixedAssetInvestment.Published6/13/2011.
2 PivotCapitalManagementReport ChinasInvestmentBoom:TheGreatLeapintotheUnknown(2011),NationalBureauofStatistics
China lacks meaningful giowth
uiiveis outsiue of expoits anu
stateuiiven investment

Expoits & uioss Capital Foimation uBP 1981 2uu9

0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
1981 1986 1991 1996 2001 2006
Gross Cap.
Form. (Fixed
Asset
Investment)
Exports
Combined
Globaldownturnliterallypavedover:
Source: World Bank
1 HSBCGlobalResearchCurrencyWeekly,06/07/2010,p.5
2 PivotCapitalManagementReport ChinasInvestmentBoom:TheGreatLeapintotheUnknown(2011),p.7. Chartsexcerptedfromsamereport.
Real estate is anothei significant uestination foi fixeu asset investment:
BSBC estimates total value of iesiuential piopeity at S.27x uBP
1
Almost2xlevelinUSbeforesubprimecrisis
ClosetoJapanesepeaklevelof3.8x
}apanese 89 uBPCapita = 14.4x China u9 uBPCapita (Constant 0SB)
Piiceincome levels top global maikets at peak of cieuit cycle
PiiceIncome 1S2ux in majoi cities, ~1ux in iegional cities
2
9x in Lonuon, 12x in Los Angeles in 2uu7
Compensating foi Something.
Noie than 1uu supeitall ( >Suum) builuings in planning oi unuei constiuction
Cuiiently only 7u builuings > Suum globally
Significant numbei of piojects financeu anu initiateu by local goveinments
Bistoiically, piojects of this scale have maikeu maiket tops
1
:
PingAnInsurancesnewShenzen
headquarters 115floors,648m under
construction
Goldin Finance117,Tianjin 117
floors,597m underconstruction.
Masterplanalsocallsfor270story
towersandresidentialhighrises
1 AndrewLawrence, TheSkyscraperIndex:FaultyTowers,PropertyReportDresdnerKleinwortWassersteinResearch (1999)
TheGuangzhouUrbanPlanningBureaus
proposedcenterpiecefortheplannedBaietan
CBD 118floors,650+m.Thedistrictwill
havemorethan10mmsq.metersoffloor
space.
ForthebenefitofAmericanreaders,ChicagosWillis(Sears)Towerisonly527mwhenits85mantennaeareincluded
Bubai X 1uuu.
Tianjin is planning an especially gianuiose cential business uistiict which is cuiiently
unuei constiuction:
Constiuction of Phase 1 of pioject is unueiway The toweiing builuing visible at centei left is to be ~6uum,
which woulu be the woilus seconu tallest if it stoou touay
China is in uiie neeu of stiuctuial iefoim:
Bepenuent on expoit economy & fixeu asset investment
Expoit impact smallei on a net basis, but pioviues ciitical
souice of foieign exchange
Nacioeconomic management uistoiting capital allocation
Nounting leveiage anu inflation
Paity iemains uominant playei in business anu finance
0tilizes maiket mechanisms selectively & on its own teims
0nwilling to ielinquish meaningful authoiity to maikets
1 BarryEichengreen,Donghyun Park,&Kwanho Shin.WhenFastGrowingEconomiesSlowDown:InternationalEvidenceandImplicationsforChina,
NBERWorkingPaper 16919(2011)4
Expeiience of othei Asian tigeis suggests giowth will slow iiiespective of inteinal obstacles
1
Niuule Income Tiap expoit mouel has limitations
Expoit & invest mouel piecluues balanceu giowth & foimation of consumei society
TemptingcomparisonstoJapanbutrealities
ofChinaareevenstarker
Consensus: China will iebalance anu ieplace 0S as global
consumei
NcKinsey Chinese uiban miuule class with spenuing powei equivalent to
}apanese householus by 2u2S ($2.4 tin)
Pioblems iecognizeu, but stiuctuial tiansition taken as a given
Reality: China cannot become a consumei nation without
significant stiuctuial iefoim
uovt. iecognizes pioblems but weuueu to statist solutions
Soft infiastiuctuie neeueu, not moie haiu infiastiuctuie
Cuiient system incompatible with consumei society
State must withuiaw fiom capital allocation
State investment ciowus out piivate entiepieneuis
Investment funueu by state banking system, in tuin funueu by
captive capital of piivate saveis
Nonstate sectoi staiveu of capital anu iesouices
Capital maikets play no meaningful iole in capital allocation
PB0C must cuitail its maiket opeiations
Nassive balance sheet expansion ciowus out uomestic
consumption, cieates uangeious liquiuity oveihang
Biviuenus fiom expoit subsiuies acciue laigely to foieign
investois anu stateowneu enteipiise
Populace has not shaieu in gains fiom giowth:
Peisonal income capita seveiely lags uBPCapita
giowth, which itself lags uBP giowth
1
Wage squeeze woiseneu by inflationasset bubbles
2
nu
laigest economy, but 9S
iu
in uBPCapita (INF)
Between Naceuonia (92
nu
) & Algeiia (94
th
)
uBPCapita oveistates income as only ~4u% flows
thiough to laboi
Labois slice of the pie is shiinking
2
:
1997 WagesuBP: SS%
2uu7 WagesuBP: 4u%
Laige wealth inequality
u.4% of Chinese contiol 4uSu% of wealth
S
uini coefficient: 47 in 2u1u accoiuing to state ests.
4
0nueistateu, excluues hiuuen income
Concentiation of wealth ieflects concentiation of
powei amongst political elites
Bow successful can the Chinese miiacle be when
so few have enjoyeu its benefits.
Source:WorldBankDevelopmentIndicators,19752008.
$0.00
$2.00
$4.00
$6.00
$8.00
$10.00
$12.00
$14.00
$16.00
S. Korea Singapore Brazil Hong Kong Mexico China
2008Avg.HourlyWage
1 A.R.KhanandCarlRiskin,IncomeandInequalityinChina:Composition,DistributionandGrowthofHouseholdIncome,1988to1995,TheChinaQuarterly 154(1998)
2 RichardMcGregor,TheParty (NewYork:HarperMacMillan)2010
3 VictorShih,HighWealthConcentration,PorousExchangeControl,andShockstoRelativeReturn:TheFragileStateofChinasForeignExchangeReserve,PresentationattheInstituteofNewEconomicThinking,Bretton Woods,NH(2011)
4 ChenJia,CountrysWealthDividePastWarningLevel,ChinaDaily,05/12/10.Accessed08/23/11.http://www.chinadaily.com.cn/china/201005/12/content_9837073.htm
Since the eaily 9us, Chinas uiban populace has been favoieu at the
expense of theii pooiei, less euucateu iuial compatiiots:
Pei capita income
1
:
0iban >$2,uuu
Ruial <$ 6uS
Limiteu job opps. 4u% of iuial population un oi unueiemployeu
2
Limiteu public seivices in iuial aieas
Cut off fiom bank cieuit, ieliant on infoimal cieuitloan shaiks
Function of concentiation of wealthpolitical powei in cities
Buoku () iuialuiban class iegistei system exaceibates uiviue:
Ruial citizens liteially seconu class citizens with iestiicteu mobility
Cieates maiginalizeu class of 1Summ migiant iuial laboieis
S
Ruial woikeis can move to cities to seek jobs, but lack access to basic
public seivices uue to iuial citizenship
0ften foiceu to woik in infoimal lowpaying jobs
Social position analogous to illegal immigiants in the 0S
1 Yasheng Huang,CapitalismwithChineseCharacteristics:EntrepreneurshipandtheState (NewYork:CambridgeUniversityPress,2008)251.
2 JasonGale&BretOkeson.ChinaDoctorsEarning$300aMonthFlocktoDrugCompanies,BloombergBusinessweek,7/10/11.
3 JohnBryanStarr,UnderstandingChina:AGuidetoChinasEconomy,History,andPoliticalCulture,3
rd
Edition(NewYork:Hill&Wang,2010)162.
4 Ibid,pp.148149.
Piivatizations of 9us uismantleu Iion Rice Bowl ()social secuiity net:
S0Es useu piivatizations to jettison lowpiouuctivity woikeis at fiims thought to be ~Su% oveistaffeu
4
Tenuieu S0E employees hau pieviously enjoyeu guaianteeu jobs anu benefits (the Iion Rice Bowl)
Restiuctuiing caiiieu out to enhance piofitability of S0Es ietaineu by goveinment
Cieateu laige gioup of stiuctuially unemployeu ~12 thought to still iemain jobless
4
Cuiient goveinment ietiiement piogiams available only to uiban iesiuents, ~9S% funueu by local goveinments
4
Local goveinments now iesponsible foi euucation,
healthcaie, anu social secuiity aftei late 8us iefoims:
Cieateu pioblematic conflicts foi local leaueis with
significant social consequences:
New iesponsibilities weie unfunueu manuates
Local officials peifoimance still assesseu by nominal giowth:
Incentivizeu to favoi shoit teim economic giowth ovei longteim
social investment
Incieasing uemanus on local leaueis paiu foi thiough
unsustainable financing piactices:
Local goveinments alloweu to iun buuget ueficits in 2uu8
Local goveinment uebts alieauy ~2S%uBP by yeaienu 2uu9!
1
Incentive stiuctuie piomotes shoit teimism in local finance
Sales of expiopiiateu piop. fiequently useu to funu buuget gaps
Aibitiaiy seizuies of peasant faimlanu, piopeity iesolu to
uevelopeis by local goveinment
7umm faimeis have lost theii lanu in this way in the past uecaue!
2
Aggiieveu citizens have little iecouise as local goveinments
woiu is law:
Seeking justice highei up the state hieiaichy uifficult anu uangeious
<1% of petitions foi ieuiess to goveinment iesolveu satisfactoiily
S
1 AnthonyChanChinasHiddenDomesticPublicDebt:SomePerspectiveontheRisksitPoses,AllianceBernstein GlobalEconomicResearchReport(2010)
2 Starr,176.
3 Ibid,84
Bealthcaie
2uuu Woilu Bealth 0iganization stuuy iankeu Chinas
healthcaie system 144
th
globally
1
Behinu Buiunui (14S
iu
), aheau of Nongolia (14S
th
)
~4u% of sick iuial iesiuents uiu not seek meuical caie uue to
its unaffoiuability
2
~6u% of iuial iesiuents iequiiing hospitalization uiu not seek
tieatment uue to unaffoiuability
2
1 public health piofessional 7,uuu people (0S 16SS)
S
Euucation
State withuiew euucation funuing in 9us
Expense uumpeu on local govts. anu subsequently passeu on to
paients in foim of incieasing school fees
Euucation costs giew fastei than CPI by 1u% in 9us
4
Inequality continues to iise:
S
Lack of tiaining uiives inequality in wages
6
Illiteiacy incieaseu 64.S% between 2uuu anu 2uuS
Equivalent to Su% of iuial school cohoits fiom 199us
7
Ruial seconuaiy school uiopout iates 4S% in uuuS
8
1 WorldHealthOrganization.WorldHealthReport2000.
2 Yasheng Huang,CapitalismwithChineseCharacteristics:EntrepreneurshipandtheState (NewYork:CambridgeUniversityPress,2008)251.
3 JasonGale&BretOkeson.ChinaDoctorsEarning$300aMonthFlocktoDrugCompanies,BloombergBusinessweek,7/10/11.
4 Carsten Holz,ChinasEconomicGrowth19782025:WhatWeKnowTodayAboutChinasEconomicGrowthTomorrowHongKongUniversityofScience &Technology,2005.
5 RaviKanbur &Xiaobo Zhang,FiftyYearsofRegionalInequalityinChina:AJourneythroughCentralPlanning,Reform,andOpenness,ReviewofDevelopmentalEconomics 9(2005)
6 Z.Liu,TheEffectsofEconomicReformsonWageInequality:SomeEvidencefromChina,AppliedEconomicsLetters,8,(2001)
7 Huang,43
8 Ibid,248
Patientsawaitingtreatment
II. Banking & Finance
Chinese finance speaks to the funuamentally pooi
piospects foi stiuctuial tiansition without iefoim:
Chinas giowth is laigely inteinally financeu
FBI is limiteu & laigely focuseu on expoit inuustiies
(i.e. offshoiingoutsouicing)
Bigh savings iate finances investment glut
Saveis unwillingly unueiwiite giowth
Banking sectoi pioviues cheap capital foi S0Es, local govts.
State sets inteiest iates anu limits investment
options foi saveis
Fixeu ueposit iates, fixeu lenuing iates = Fixeu NIN
Cieates cheap, captive capital foi state banks
Real ueposit iates fiequently negative
Be facto tax on Chinese saveis
Alteinatives foi saveis iestiicteu to stocks, RE
Encouiages speculation, uistoits asset piices
Shifts investment to uniegulateu shauow
banking system
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
1982 1987 1992 1997 2002 2007
FDI, % of
GDP
Gross
savings, %
of GDP
Source: PBOC, Bloomberg
1 Walter&Howie,44;YangKaisheng,SeveralThoughtsaboutStabilizingtheCapitalAdequacyofourCommercialBanks,21
st
CenturyBusinessHerald,04/13/2010
Inourcountryscurrentlevelof
macroeconomicdevelopment,wemust
maintainalevelofmacroeconomic
growthofaround8%perannumand
thiswillinevitablyrequirea
correspondinglevelofcapital
investment.Ourcountrysfinancial
systemisprimarilycharacterizedby
indirectfinancing(viabanks);the
scaleofdirectfinancing(viacapital
markets)islimited.
YangKaisheng (),CEOof
Industrial&CommercialBankofChina
1
1 Saez,Lawrence,BankingReforminChinaandIndia,(NewYork:PalgraveMacmillan,2004)
2 CarlWalter&FrasierHowie,RedCapitalism:TheFragileFinancialFoundationofChinasExtraordinaryRise,(NewYork:JohnWiley&Sons,2011)
CapitalRaisingActivity 1993 2009
Source: PBOC Financial Stability Report 2010
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Bonds
Bank Loans
Equity
The subsiuizeu uomestic banking system finances almost all economic activity
1
:
Bank loans & bonus account foi ~9u%of coipoiate finance
1
Equity financing immateiial
Foieign banks <2% of financial assets
2
Keeps capital maiket exposuie to a minimum
1 Walter&Howie,86.
Chinas ieliance on its state banking system
is unueistateu as coipoiate bonus aie not
mateiially uistinguishable fiom bank loans :
7u% helu to matuiity by state banks
1
22 of 24 piimaiy uealeis aie state banks
1
0nueiwiiting bonu anu ietaining
cieuit iisk effectively a loan
The Chinese yielu cuive is a constiuction of
the state:
0ses stateset bank 1 yeai uepositiate as a
baseline
Tiauing volume is insignificant yielu cuive
can be uiawn aibitiaiily
Bonus issueu anu solu piimaiily to goveinmentcontiolleu entities:
Solu at below maiket coupons
Selling unattiactive foi holueis
Cieates losses uue to belowmaiket issuance; politically unappealing
Illustiative of Paitys supeificial auoption of maiket institutions:
Stiuctuie auopteu to maximize paitys ability to limit the impact of maiket foices
Institutional chaiactei infoimeu by eailiei expeiiences with ietail bonu maiket
The banking system is Chinas ue facto seconu tieasuiy:
Capital allocation system funuamentally unchangeu since 7us
Paity views banking system as policy tool anu as a vehicle foi
peisonal eniichment
The Paity contiols the banking system
The banking system funus almost all economic activity
We now will biiefly ieview the cuiient state of Chinese banking:
o Capital is often politically uiiecteu anu useu by local
officials to accomplish the paitys economic taigets
o Senioi bank officials & S0E manageis selecteu by
nomenklatuia system
o Paity ietains majoiity equity owneiship & ultimate
contiol
1 Bankannualreports,various,PBOCAnnualSurvey&Statistics2010.
Coipoiate banking in China is uominateu by 4 laige
statecontiolleu banks (The Big 4) anu theii emeiging
iival BoCom:
Piimaiy tools of state in managing the economy:
A seconu tieasuiy
Bespite puipoiteu commeicialization anu public
listings govt. influence iemains significant
Cieuit fiequently extenueu on the basis of peisonal
ielationships iathei than peiceiveu cieuitwoithiness
Listeu with shaie of uomestic financial assets as of 12S11u
1
:
Bank of China (B0C) 17.u%
China Constiuction Bank (CCB) 17.6%
Inuustiial & Commeicial Bank of China (ICBC) 21.9%
Agiicultuial Bank of China (ABC) 16.8%
Bank of Communications (BoCom) 6.4%
Emeiging iival to Big 4
Initially foimeu as state policy banks, latei commeicializeu in eailymiu 9us
Politicizeu goveinment. ietains majoiity owneiship anu contiols boaius of uiiectois;
peisonnel must be goveinment appioveu
79.7% of uomestic financial assets
1 BankAnnualReports,PBOC.
The coie of the banking system is iounueu out by the
explicitly statist policy banks:
Listeu with shaie of uomestic financial assets as of 12S11u
1
:
China Bevelopment Bank (CBB) 8.S%
Agiicultuial Bevelopment Bank of China (ABB) 2.8%
China ImpoitExpoit Bank (CIE) 1.4%
China Postal Savings Bank (CPSB) 0nuiscloseu
Foimeu in 1994 to take ovei policy loans fiom newly
commeicializeu Big 4 as pait of laigei fin. sectoi iestiuctuiing
Bespite stateu mission, majoiity of activity is inuistinguishable
fiom opeiations of commeicializeu Big 4
ChinaDevelopmentBank(CDB)
Paiticulaily impoitant in iecent yeais:
Leu by Revolutionaiy piinceling son of
Chinas foimei supieme state plannei , Chen Yun
Lendingvol.onparwithMinistryofFinance
12/31/2010loanbook2XWorldBanks
Soveieign wealth funu, but majoiity of
investment is uomestic
7u% funueu by commeicial banks (Big 4)
Shift to univeisal bank stiategy has leu state
competitois to similaily uiveisify business lines
Intiouuceu new secuiitizeu piouucts
Exemplifies expansion anu ambition of state
contiolleu financials
Financiei of state ego piojects
Thiee uoiges Bam, Shanghai Puuong Aipoit,
Beijing 0lympic piojects, etc.
Policy Banks ex. CPSB 12.6% of total financial assets
Big 4 + B0C0N + Policy Banks ex. CPSB= 92.S% of
total financial assets
Concentiation has incieaseu in past uecaue
Centialization of finance aius anu abets paity contiol
Ifitdoesnthaveaccesstoastableandsufficientsourceofcapital,theChinaDevelopmentBankwillbe
unabletooperatenormally
Anonymous, Tieasuiy Bepaitment, CBB. Quoteu u1111u in TheEconomicObserver ()
5- Year Asset CAGR ROA
RE Loans /
Total Loans
OBS
Commitments
/ Total Loans
NPL
Ratio
Tier 1
Capital
C
o
m
m
e
r
c
i
a
l

B
a
n
k
s
Bank of Communications 22.7% 1.1% 9.8% 75.5% 1.1% 9.2%
China Construction Bank 18.7% 1.4% 8.9% 44.0% 1.3% 10.3%
Bank of China 17.2% 1.1% 29.1% 84.2% 1.2% 10.0%
Agricultural Bank of China 16.7% 1.0% 26.6% 14.1% 2.3% 9.6%
Industrial & Commercial
Bank of China 15.8% 1.3% 27.0% 54.3% 1.2% 9.7%
P
o
l
i
c
y

B
a
n
k
s
China Development Bank 21.9% 0.8% N/A N/A 0.6% N/A
Agricultural Development
Bank 15.5% N/A N/A N/A 1.1% N/A
Export-Import Bank 44.9% N/A N/A N/A N/A N/A
Postal Savings Bank N/A N/A N/A N/A N/A N/A
Commercial Bank Average: 18.2% 1.2% 20.3% 54.4% 1.4% 9.8%
Policy Bank Average: 27.4% N/A N/A N/A 0.9% N/A
Average: 21.7% 1.1% 20.3% 54.4% 1.3% 9.8%
CDB figures as of 12/31/09 (most recent), NPL figure reflects provision for loan losses as NPLs are undisclosed. Export-Import Bank figures as of 12/31/09 (most recent). All other figures as
of 12/31/10
With aggiessive loan giowth anu weak cash flow geneiation, Chinese banking is
unusually capital intense anu iequiies constant iefieshment.
Anu yet, >Su% of uS1u & 9S% of u71u new equity capital paiu in uiviuenus!
This ouuity is moie explicable when we iecall that vast majoiity of bank uiviuenus acciue to
the state
(300,000)
(200,000)
(100,000)
0
100,000
200,000
300,000
400,000
2005 2006 2007 2008 2009 2010
Proceeds from
Sale of Common
Stock
Dividends Paid
Source: Bloomberg, Bank annual reports
EquityOfferings&DividendPayouts,Big4Banks,20052010
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
Dec-99 Nov-00 Nov-01 Nov-02 Nov-03 Nov-04 Nov-05 Nov-06 Nov-07 Nov-08 Nov-09 Nov-10
Domestic Credit
GDP
Source: PBOC, Bloomberg, billions of RMB
CreditisgrowingfasterthanGDP
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10
Total Loans of
Fin. Institutions,
YoY (L. Axis)
NPL Ratio (R.
Axis)
Loan giowth has sloweu but iemains uangeiously high
Source: PBOC, Bloomberg
NPLs appeai minimal but aie a backwaiulooking inuicatoi in a loose cieuit enviionment
Stimuluswall:banksgivengreenlightforgrowth:
Chinas state financial system has histoiically faieu pooily &
has an unfoitunate tiack iecoiu
1
:
2 majoi events since 1978:
Late 8us Eaily 9us
Piovincial goveinois contiolleu PB0C bianches
Local officials oveicook giowth - 2u+% inflation
Inflationaiy spike foiceu total halt of bank lenuing
Spaikeu haiu lanuing ieal estate ciash in Bainan
Late 9us Eaily uus
Inuuceu by Asian Financial Ciisis (AFC)
0niesolveu NPLs fiom pievious ciisis compounueu impact
of new wave of bau loans 4u% of pie2uuu loans bau!
2
uovt. iesponse leu to cuiient maiket stiuctuie
Bistoiical recoveryratesinthe1020%range on bau loans
Compaie to iecoveiies ~6u% at peak of 0S S&L Ciisis
Suggests lack of tiue piofit motive in lenuing, likelihoou of fiauu anu
theft at the maigin
Without exteinal shocks (i.e. AFC) state can uelay ieckoning inuefinitely
Incomplete iefoims
Pievious ciises iesolveu by cieative accounting toppeu up with small
infusions of foiex ieseives anu capital iaiseu fiom IP0s
Peiceiveu success of bank iecaps. anu subsequent collapse of Westein
financial system has ieuuceu peiceiveu neeu foi iefoim
1 VictorShih,Factions&FinanceinChina:EliteConflictandInflation,(NewYork:CambridgeUniversityPress,2007
2 Walter&Howie
1 ThomasBottini,BankruptcyPerilsinChina:TheGITICTale,MultinationalBusinessReview 115(2003)
uITIC Foieiunnei of touays banking sectoi.
Engageu in piactices common in mouein Chinese finance (i.e. off balance
sheet vehicles, giowth of noncoie business lines, politicizeu lenuing)
Fiist anu only Chinese financial alloweu to fail
Lenuei anu secuiities co. effectively contiolleu by local goveinment
Bong Kong listeu subsiuiaiy issueu bonus in 0S
uovt. pioviueu comfoit letteis foi uITICs inteinational ueals
Explicit assuiance that state stoou behinu the bank
Enoimous expansion in 9us aiueu by Westein banks
0ne of Chinas fiist inteinational playeis
Went bust in wake of Asian financial ciisis }anuaiy 1999
NPL iatio: 9u.u%
1
Recoveiy iate: 12.S%
1
Fiist anu only bankiuptcy of majoi Chinese financial:
Assets: $2.6 bn
Claims: $S.6 bn ($4.7 bn to foieign cieuitois)
Inteinational exposuie piompteu laigei concein iegaiuing Chinas solvency
Necessitateu immeuiate action anu a tianspaient liquiuation piocess:
Appointeu KPNu to builu cieuibility with westeineis
GITICSformerheadquarters;3
rd
tallest
buildinginAsiaattimeofconstruction
1 Walter&Howie
2 Bottini
Piioi to uITIC, the PB0C closeu failing banks anu maue foieign cieuitois whole:
Compaiatively small scale of financial sectoi anu limiteu inteinational exposuie alloweu govt. to easily
settle the bill
PB0C put ieflecteu in bonu iisk:
8 mos. befoie collapse, uITIC bonus yielueu just 24u bps ovei Tieasuiies
1
0nuei banking law, banks weie iequiieu to iegistei uebts to foieigneis with govt.
Intenueu to piotect foieign cieuitois; uniegisteieu uebt unenfoiceable
uITIC useu Bong Kong subsiuiaiies to hiue oveiseas uebts
Biveisifieu into wiue vaiiety of opeiating businesses:
2
Nanufactuiing, textiles, hotels, etc.
0iiginally thought to have 66 uomestic anu 66 oveiseas subs.
1uS uomestic anu 1SS oveiseas subs. uncoveieu
Scale of uebts leu to closuies of many tiust companies anu iecentialization of Big 4 unuei
cential goveinments contiol
PostuITIC iefoims sought to iecentialize contiol ovei the financial system
Not about enhancing capital allocation
No intention of allowing tiuly piivate banking oi floating inteiest iates
While the piovincial uITIC was alloweu to
fail, China puisueu moie innovative
solutions to iesolving the banks unuei the
uiiect contiol of the cential goveinment in
the late 9us eaily uus
Paiticulaily impoitant to the iecapitalization
anu unueipinning Chinas financial system
aie the 4 asset management cos. (ANCs):
Chinas4AMCs:Orient,Huarong,GreatWall,andCinda
Bau banks useu to iemove pioblem loans fiom bank balance sheets
Cieateu to ueal with piimaiily late 8useaily 9us vintage NPLs that iemaineu fiom past ciises:
uovt. uelayeu iesolution until exogenous shock of AFC uemanueu action
4u% of pie2uuu loans nonpeifoiming
1
ANCs acquiieu RNB 2.4tin+ of bau loans to iecapitalize financial system
ANCs funueu by PB0C ANCs puichase NPLs at face value 1uus on the uollai
ANCs iesemble uevelopeu woilu bau banks (i.e. RTC in 0S S&L ciisis), but ciitical uiffeience:
Banks ieceiveu ANC bonus an unfunueu ieceivable no cash into banks
Accounting solution; banks ietain exposuie to bau loans
1 Walter&Howie
Intenueu as tempoiaiy institutions, the
ANCs 1999 manuate was ieneweu in 2uu9
foi a fuithei 1u yeais:
Thinly capitalizeu; inevitably insolvent
Negligible capital base anu inflateu puichase
piice of loans maue piofitable opeiation
impossible fiom the beginning
Significant opeiating expenses exaceibateu
ueaith of loan iecoveiies (~11% by uS)
1,2
uoveinment has hau to pioviue comfoit
letteis to auuitois to assuie solvency
Noie iecently the elegant ANC system has
been abanuoneu in favoi of uiiect issuance of
unfunueu ieceivables by the Ninistiy of
Finance (N0F):
Nechanics iemain the same; banks ieceive
unfunueu, eveigieen I00s
ANC bonus anu subsequent N0F ieceivables aie
significant state liabilities not ieflecteu in heauline
soveieign uebt figuies
1 Shih(2007),174
2 Neina Wang,Thetotalassetsandliabilitiesinthebankingsectorgrowbyapproximately19%Zhongguo Zhengquan Bao (ChinaSecuritiesNews),10/12/05
ANCs like Cinua have
oppoitunistically useu the
licenses of theii seizeu poitfolio
companies to entei a wiue
vaiiety of business lines,
significantly expanuing beyonu
theii oiiginal manuate:
Seizeu opeiating businesses
continue as going conceins
Employ >12,uuu people
Bau banks now uiveisifieu
conglomeiates
0peiating losses woisen alieauy
weak financial position
Cinuas subsiuiaiies span life insuiance, P&C
insuiance, secuiities biokeiage, equipment finance,
futuies tiauing, investment management, ieal estate
investment, tiust management, piopeity
uevelopment, constiuction, anu even incluue
inuustiial businesses.
AselectionofsomeofCindas publicallyacknowledgedsubsidiaries
ANC bonus anu latei N0F
ieceivables compiise a
significantportion of the
Big 4s capital base:
Big 4 Banks - Big Balance Sheet Holes
in billions of RMB BOC CCB ICBC ABC
1998 MOF Bond 42.5 49.2 85.0 93.3
1999 AMC Bonds 160.0 247.0 313.0 0.0
2007 MOF Receivable 0.0 0.0 62.3 635.5
2004 PBOC Special Bills 0.8 63.4 434.8 0.0
2006 PBOC Target Bills 113.5 0.6 0.0 0.0
2007 PBOC Bills and Bank Sub-Debt 14.6 57.1 237.1 0.0
Total: 331.4 417.3 1,132.2 728.8
Total Assets: 8,748.2 9,623.0 11,785.1 8,882.6
Total Capital: 608.3 492.0 586.4 342.8
AMC Bonds/Total Capital: 26.3% 50.2% 53.4% -
Source: Audited financial statements. 12/31/2009 values.
Bonus iolleu with ANC manuate
Eveigieen NPLs:
0luest unueilying loans iepoiteuly
uate to late 8us anu eaily 9us
Continueu piesence on bank
balance sheets speaks to kick the
can appioach to iestiuctuiing
Banking system iests on shaky
founuation of accounting tiickeiy
Investois awaie of potential balance
sheet holes but believe in PB0CN0F put
Assumption that state will be able
to ieplicate uITIC iestiuctuiing
Confidenceinthebankingsystemreflectsinvestorconfidenceintheabilityof
thestatetorecapitalizefinancialsystem largeforex reservesprovideillusory
comfort
th
The PB0C even has its own bau bank useu to hiue uebts & uisguise its piobable insolvency:
Buiua Asset Nanagement
Cieateu in 2uuS in oiuei to iemove pioblem loans fiom PB0C balance sheet
Funueu by Cinua Asset Nanagement Co.
0tilizeu uue to close political ties to PB0C
0paque, no uisclosuie on opeiations as poitfolio has not been maiketeu to outsiue
investois, in contiast to moie tianspaient 1
st
geneiation ANCs
0fficial uocuments suggesteu Buiua was to acquiie ieal estate loans fiom
Bainanuuangxi anu poitfolios fiom the uITIC bankiuptcy (miulate 9us vintages):
Belief among maiket paiticipants is that Buiua insteau acquiieu the PB0Cs oiiginal ANC loans
in oiuei to ease piessuie on insolvent ANCs
1
This woulu imply a iounutiip investment that woulu offset anu uisappeai if the entities weie
consoliuateu
0nauuiteu, off balance sheet vehicle foi PB0C anu Cinua
0nlisteu anu unmentioneu on Cinuas website; fiscal black hole
1
1 Walter&Howie
State Council
Ministryof
Finance
PBOC
Financial Regulatoiy
Soup (NBRC, CBRC,
CSRC, CIRC)
State0wneu Assets
Supeivision & Auministiation
Commission
(SASAC)
S0Es
China Investment
Coip. (CIC)
Cential Buijin
Investment
Cential SAFE
Investment
Asset Nanagement
Cos. (Buaiong, 0iient,
uieat Wall, Cinua, Buiua)
Big 4 anu China
Bevelopment Bank
The Ninistiy of Finance, opeiating uiiectly unuei the State Council, lies at the heait of the contempoiaiy Chinese
financial system:
The PB0C has been ielegateu to a seconuaiy iole aftei suffeiing a significant eiosion of its powei in the eailymiu uus
PB0C foimeily contiolleu Big 4 & CBB via Cential SAFE Investment
Bivisions between the PB0C & N0F ieflect alteinate caieei paths within the paity
1
:
N0F uominateu by geneialists: Typically iotateu between ministiies anu localities
Bistoiically has favoieu uecentialization of financial contiol, economic giowth ovei piice stabilitysocial welfaie
PB0C uominateu by Technociats: Typically auvanceu thiough silo hieiaichy of PB0C
Bistoiically has favoieu centialization of finance anu piioiitizeu piice stability
1 Shih(2007)4763
The cuiient owneiship & iegulatoiy stiuctuie of Chinas financial system
is the piouuct of stillboin iefoim:
PB0C leu iefoim anu iestiuctuiing piocess in late 9useaily uus
Instituteu ANC system & initiateu IP0s of Big 4 in Bong Kong
PB0C intenueu to pioceeu with fuithei piivatization anu financial libeialization
N0F acteu oppoitunistically to seize contiol of most impoitant leveis of powei befoie
the PB0Cs iefoims coulu be completeu
N0Fs political ascenuancy stiongly ieuuceu the likelihoou of fuithei iefoim
We now biiefly ieview the political stiuggle between the PB0CN0F:
Regulatoiy iefoim has been hampeieu by
inteinal conflicts between the tieasuiy
(N0F) anu the cential bank (PB0C)
This conflict is ieflecteu in the countiys uueling
soveieign wealth funus (SWFs):
China Investment Coipoiation (CIC)
Cential SAFE Investment (SAFE)
ThenondescriptentrancetoMOFheadquartersinBeijing
Peiceiveu success of iestiuctuiing via ANCs impeueu fuithei iefoim:
Neuia outciy aftei subsequent sales of minoiity stakes in piizeu state assets to foieigneis
9% of CCB solu to Bank of Ameiica, S% to Temasek (Singapoiean SWF)
Neuia consensus: if the banks hau just been successfully iecapitalizeu, why sell to foieigneis.
1
Exaceibateu alieauy hostile elements in the N0F anu othei iival state ministiies stemming
fiom the PB0Cs inuepenuent cieation of a commeicial papei (CP) maiket:
2
PB0C hau pieviously ceueu iegulatoiy powei ovei fixeu income to the State Planning Commission
Cieating CP maiket unueimineu this authoiity, geneiateu iesentment amongst political iivals
Suuuen ueath of PB0C suppoitei Buang }u fiom pancieatic cancei in 2uu7 shifteu balance
of powei towaius N0F:
Piominent suppoitei of }iang Zemin anu the Shanghai clique, swoin enemy of Bu }intao
Politbuio Stanuing Committee membei one of the most influential politicians in China
Bau favoieu centialization anu suppoiteu PB0C in its iefoimcentialization effoits
Reflects significant influence of inuiviuual politicians in ueteimining ciitical policy outcomes
Paity committee gianteu N0F appioval in 2uu7 to founu China Investment Coipoiation
(CIC), a SWF to iival SAFE, the PB0Cs existing soveieign wealth funu:
N0F hau blameu PB0C foi iising inflation, accuseu it of pooi management of ieseives
S
1,2 Walter&Howie,1718
3 Ibid,131
It is thiough CIC that the N0F has
enfoiceu its uominance ovei the PB0C
anu taken contiol of the state banks
1
:
Cential SAFE Investments (SAFE)
Cieateu by PB0C to top off Big 4 with foieign
exchange ieseives in tanuem wANC bonus
2uuS $4S bn to CCBB0C
2uuS $1S bn in ICBC
Filleu iemainuei of gap too laige to be pluggeu
by accounting gimmicks (i.e. ANC bonus)
Foimei contiolling shaieholuei of Big 4,
majoiity iepiesentation on boaius of Big 4CBB
via Buijin Investment (Buijin)
China Investment Coipoiation (CIC)
Funueu by RNB 1.SS tin Special Bonu solu by N0F to PB0C in 2uu7
PB0C then foiceu these below maiket coupon bonus on banks
N0F useu pioceeus to buy $2uu bn in foieign exchange ieseives fiom PB0C
0SB ieseives useu to capitalize CIC
~1S of pioceeus useu foi SWF investment
Remainuei useu to iecapitalize ABCCBB anu to puichase Buijin (anu by extension the Big 4 & CBB) fiom PB0C
Aftei CICs acquisition of Buijin, N0F uiiectly contiols Big 4 anu CBB
Banking system is now uiiectly owneu by state tieasuiy
1 Walter&Howie,127138
III. Paity & State
The paity not only ietains significant influence in allocating capital but continues to
uominate inuustiy by favoiing stateowneu enteipiise anu influencing peisonnel appointments
Westein consensus: Biiection of iefoim since 1978 has iemaineu constant
uiauual iefoim anu libeialization; incieasing embiace of piivate economy anu maiket mechanisms
amiust a uismantling of Stalinist centialplanning appaiatus
Reality: Nany stiuctuial iefoims have laigely been ieveiseu postTiananmen
Inciemental iefoim has occuiieu, but efficacy is limiteu by govt.s uistiust of uniestiicteu maiket
mechanisms anu by the ability of vesteu inteiests to ciicumvent iefoims at the local level
0nueistanuing the political uynamic since 1978 is ciitical to unueistanuing the
cuiient anu futuie uiiection of iefoim:
WebrieflyreviewthestructureoftheChinesegovernmentbefore
summarizingthedecadessincereform:
Thelastthirtyyearshavebeengreatononelevel.Theeconomyhasadvanced,butculture,
society,andpoliticshavenot.Inessence,itisthesameoldsystem.
Wang Xiaofang, foimei paity buieauciat
1
1 Hongru Liu,TheFormationoftheThinkingandReformProposalsforChinasFinancialSystemReforms,2000.
China has been iuleu by the Communist Paity of China since 1949:
The Paity exists above the law anu the goveinment:
Tiue locus of political anu economic powei
Authoiity of the paity supeiseues all otheis
Accoiuingly, piominent politicians typically holu concuiient ioles within
goveinment anu paity:
e.g. Bu }intao is both ueneial Secietaiy of the Communist Paity of
China anu Piesiuent of the Peoples Republic of China
Paity ietains powei of appointment while paity agencies (i.e. Cential
0iganization Bept. et. al.) monitoi peifoimance of appointeu officials
TheHammer&SickleoftheParty
Paity leu by 2Speison Politbuio
Nominally appointeu by Paity Cential Committee but selfpeipetuating in piactice
Agenua uictateu by ueneial Secietaiy, uecisions achieveu by consensus
Neets monthly
The Politbuio is in tuin uominateu by the Stanuing Committee of the Politbuio:
Consists of 9 most poweiful membeis of Politbuio Chinas boaiu of uiiectois
Nembeis iepiesent all majoi policy aieas
The contempoiaiy stanuing committee is incieasingly stiuctuieu to check the excesses of
inuiviuual peisonalitiesoffices, i.e. the uictatoiial powei of the geneial secietaiy
Collective wisuom of committee ieplaces coie leaueis (e.g. Beng Xiaoping, }iang Zeming)
Thought to meet on a weekly basis
0niestiicteu by the iule of law, Chinese
goveinment is inefficient anu inequitable:
Chinas constitution is a mission statement
iathei than a legal uocument
1
:
4 veisions since 49, most iecent veision auopteu
~Su yeais ago anu mouifieu 4 times subsequently
0npieuictable policy enviionment with fiequently
changing iules & uegiees of enfoicement
Without checks anu balances & effective
enfoicement mechanisms, policy making &
implementation aie fiequently inuistinguishable
Regulatoiy stiuctuies often ieflect inteinecine
political conflicts (i.e. N0F vs. PB0C)
1 Starr,60
2 Starr,64
3 WangJingqiong.BeijingtoCloseThousandsofLiaisonOffices.ChinaDaily,01/25/2011.
Petitionerspleadforrelieffromthecorruptionoflocalofficials
Chinas goveinment is not a feueial system:
2
The goveinment ielies on negotiateu ielationships between a laige numbei of inuiviuual
politicians, agencies, anu oiganizations:
Paiticulaily maikeu in ielationship between cential anu local goveinments
Policy is auhoc anu negotiable as cential govt. has limiteu ability to enfoice policy at local level
Ability of local govts. to negotiate concessions fiom cential govt. ieflecteu in >1u,uuu liaison offices (i.e. local
goveinment lobbies) in Beijing A Chinese K Stieet
1
Poweiful local leaueis can iun juiisuictions as peisonal fiefs (i.e. Shanghai Clique in 9us, Chongqing in uus)
Abuses can only be stoppeu by conceiteu effoit fiom centei (i.e. coiiuption scanualsscapegoating of
pioblematic officials via Cential Committee foi Biscipline Inspection)
Nominally S bianches of goveinment:
Executive State Council
Souice of powei anu authoiity
Composeu of heaus of 26 state commissions anu ministiies (i.e.
Ninistiy of Finance, Ninistiy of Railways, Ninistiy of State
Secuiity, etc.)
State ministiies thought to employ >1umm buieauciats
Complicateu management stiuctuie local buieaus iepoit to local
govts. as well as to ministiycommission senioi office
Fuithei hinueis efficient iegulationauministiation
enfoicement of localities by the centei
}uuicial Supieme Peoples Couit
No ieal inuepenuent powei exists solely to apply paity policy
to specific casesinciuents
Legislative National Peoples Congiess
Bistoiically a iubbei stamp legislatuie, conceiveu of piimaiily
as an aiena wheie iegional uelegates coulu come to leain anu
unueistanu the masspaity line
Belegates now acting with incieasing inuepenuence (i.e. abstaining
fiom votesvoting in uissent), but still without any ieal
inuepenuent legislative authoiity
Theviewfromthetop
In the absence of a stiong feueial goveinment, the euicts of the State
Council & the laigei paity supeistiuctuie filtei thiough the laigely
inuepenuent hieiaichy of local goveinments:
Political capital of local officials ueteimines ielative inuepenuence fiom
centei anu othei govt. bouies
0fficials at one level contiol the level immeuiately below them via:
Powei of appointment
Powei to uiaft buugets anu levy taxes
Contiol ovei the allocation & ieuistiibution of iesouices
Since 2uu8, peimitteu to iun fiscal ueficits:
Local officials incentivizeu to geneiate shoit teim giowth at all costs
Bebts alieauy est. at RNB 1u.7 tin by cential govt. in }une 2u11
1, 2
2S piovincial goveinments, fuithei uiviueu into:
>Suu Piefectuies (incluuing numeious piefectuie level city govts.)
~2,9uuu Counties (Avg. pop. of ~Suuk)
~6Su+ Cities fuithei uisaggiegateu into:
~17S,uuu Townships
>9Su,uuu villages
Countless Bistiicts, Neighboihoous, anu 0nits (uanwei)
Each of these units exists in vaiious foims, ieflecting the auhoc
anu iiiegulai stiuctuie of local goveinments:
ShanghaiMunicipalGovernmentBuilding
PeoplesGrandHallinChongqing,seatofthelocal
municipalgovernment
1 FitchWarnds OverChinaLocalGovernmentDebtBBCNews,09/08/11.Accessed09/27/11.http://www.bbc.co.uk/news/business14836386
2 YinNongzhing,DeputyDirectorofFinanceCommittee,NationalPeoplesCongressstatedthatRMB10trn wasaconservativeestimateoflocalgovernmentdebt.QuotedininterviewwithReuters,02/02/11.Accessed8/23/11.
http://www.reuters.com/video/2011/02/02/chinafacingahiddendebtcrisis?videoId=183875158
Biie neeu foi iefoim in afteimath of Cultuial Revolution
Economy in tatteis, paitys cieuibility shot aftei blooubath leu by Reu uuaius
China came closest to achieving legitimate maiketoiienteu
iefoim in the 8us:
Zhao Ziyang anu Bu Yaobang leu piagmatic iefoim movement
Bisciples of Beng Xiaoping, iose thiough Communist Youth League
Eveiy single impoitant political iefoim occuiieu in the 198us
1
Nanuatoiy ietiiement of officials, iefoim of Paity Congiess, legal iefoims, etc.
Effoits to inciease auministiative autonomy of local goveinments
Alloweu piivate cieuit & floating inteiest iates
Peimitteu limiteu piivate banking with state banks benchmaikeu against
piivate financials
Paity biiefly fliiteu with ielinquishing contiol ovei capital allocation
Refoim anu subsequent giowth pieuominantly iuial
Aieas most affecteu by uieat Leap Cultuial Revolution leu iefoim
Biiven by piagmatic local officials who fiequently weie acting
inuepenuently of the centei, paiticulaily in the pooiest piovinces
Cities iemaineu uominateu by S0Es anu cential planneis
1Minxin Pei,ChinasTrappedTransition:TheLimitsofDevelopmentalAutocracy,(Boston:HarvardUniversityPress,2006)11.
Zhao(top)&Hu
Architectsofreform
Town & village Enteipiises (TvEs) leu iuial giowth spuit :
Leu by piivate entiepieneuis, who weie given significant access to cieuit
fiom localities anu Ruial CieuitFinance Coopeiatives (RCCsRFCs)
RCCs ~7S% of agiicultuial loans, ~Su% of all loans to TvEs
Bespite Westein acauemic consensus (Stiglitz et. al.), successful TvEs
weie piivately owneu & contiolleu:
0utput, piofit, anu wages of piivate TvEs Su7u% highei than state
manageu TvEs
1
Local govts. subsequently expiopiiateu best piivate assets in 9us
Economic giowth matcheu by welfaie gains foi majoiity of population
Ruial householu income 12.2% ieal giowth fiom 7888
2
1 Qisong Lin,PrivateEnterprises:TheirEmergence,RapidGrowth,andProblems,InChinasRuralIndustry,editedbyWilliamA.Byrd.(Oxford:OxfordUniversityPress,1990)181.
2 Huang117.
Nian Guangjiu founded
IdiotsSeedssunflower
seedsin1982andis
representativeofthe
dynamicentrepreneurial
classthatemergedasthe
statelooseneditsgrip.
Nian wasoneofthe
greatestTVEsuccess
storiesofthereformera,
earninga1mmRMB
profitin1986.Inthe90s
hewasjailedwhilehis
businesswasseizedand
subsequentlyrunintothe
groundbytheprovincial
government.
A Biilliant Iuiot:
Inflationaiy suige & subsequent aggiessive
monetaiy tightening , iising youth unemployment
culminateu in Tiananmen
}aiiing foi iegime but bioauei uniest was limiteu uue to
mateiial piospeiity of iuial citizens unuei 8us iefoims
Tiananmen anu subsequent leaueiship changes leu to
many iefoims being ieveiseu in the 199us
Bu Yaobang foiceu out in 86 following suppoit of stuuent
piotests; his ueath in 89 was a paitial tiiggei foi Tianamen
Zhou Ziyang puigeu foi suppoiting Tiananmen stuuents
Replaceu by }iang ZemingZhu Rhongji The Shanghai Clique
PostTiananmen lesson libeialization must not entail
loss of political contiol
Focus shifteu fiom iuial entiepieneuiship to state
uominateu uiban economy
Foieign capital systematically favoieu ovei inuigenous
entiepieneuis
1
1 Pei(2006)
In the 9us China embiaceu state capitalism unuei }iang Zeming & Zhu Rhongji
Paity supeificially embiaceu some maiket institutions but incieasingly encioacheu on enteipiise anu finance
thiough gieatei centialization anu a selective ieveisal of eailiei iefoims
Favoieu uiban S0Es anu foieign capitalists ovei inuigenous entiepieneuis
Rapiu uevelopment of coastal enclaves like Shanghai, Bongguan, Shenzen, etc. active couitship of FBI
Restiicteu access to financing foi nonstate business, gianteu geneious subsiuies to S0Es
Ruial anu uiban income giowth stalleu as nominal giowth took piimacy
Auministiationfiscal management of iuial localities iecentializeu, lost fiscal autonomy
Ruial tax buiuen giew significantly, pioceeus useu to subsiuize uiban giowth
Ruial householu income giew just S.8% fiom 89u1 uBP annualizeu 16.S% same peiiou
1
uovt. buieauciacy ~2x uuiing uecaue
uovt. payioll up fiom 2umm in the eaily 9us to 46mm in 2uu4
2
Significant iecentialization of finance leu by Zhu Rhongji to contiol miu 9us inflation
Piivate financial institutions banneu by 1998,
S, 4
imposeu nonpeifoiming loan ieuuction quotas on banks
Est. Cential Finance Woik Commission (CFWC) to iegain authoiity ovei bank bianches fiom local officials
S
}iang Zeming subsequently looseneu iestiictions, iesumeu uecentialization in eaily uus
Zhu Rhongji suppoitei Wang Xuebings coiiuption scanual paitially shifteu political balance
Welloff society giowth initiative uesigneu to cement }iangs legacy in his final yeais, iequiieu cieuit giowth
1 Huang(2008),117
2 AlbertPark&Minggao Shen.JointLiabilityLendingandtheRiseandFallofChinasTownshipandVillageEnterprises.DepartmentofEconomics,UniversityofMichigan(2001)
3 Shih(2007),177
34 Shukai Zhao,Bianju Zhong DeZiangzhen Jigou [ChangingTownshipOrganizations],StateCouncilInvestigationandResearchReport 168(2004)
5 Shih(2007),169
Chinese peasants, youi name is miseiy
Sun Bawu, iuial entiepieneui in Bebei piovince
4
th
geneiation leaueis Bu }intao & Wen }iabao
1
st
geneiation to inheiit iule as pickeu successois
Selecteu anu usheieu in by coie leauei }iang Zeming
Reflects incieasing buieauciatization of paity
Bu }intao Piesiuent of PRC, Paity ueneial Secietaiy
Consensusbuiluei, shifteu policy piioiities fiom economic giowth
towaius sustainable uevelopment anu social welfaie (scientific
uevelopment)
Policy stiives to cieate a society centeieu aiounu a piospeious miuule
class (haimonious society)
Rose thiough China Communist Youth League (CCYL) anu ietains
significant pationage netwoik of CCYL alumni
Wen }iabao Piemiei of PRC, Secietaiy of State Council
Populist iefoimei; iose unuei the pationage of Bu Yaobang, who
appointeu Wen to the Cential CommitteePolitbuio
Socially moueiate, incieasingly outspoken piogiessive
Potentially sympathetic to political iefoim
Remainuei of Stanuing Committee uominateu by foimei
membeis of }iang Zemins Shanghai clique
6 incumbents inhibit anu complicate iefoim piocess
Bifficulties intensifieu by significant expansion of state buieauciacy
(anu pationage netwoiks by extension) unuei }iang Zeming
Hxi shhu
Harmonioussociety
Paity is incieasingly cognizant of potential pioblems,
but iemains weuueu to statist solutions
18
th
S Yeai Plan ieflects this appioach:
uoal: Rebalance economy on a sustainable footing anu
ieuuce iuialuiban inequality
Plan: $1.S tin in infiastiuctuie spenuing, suppoit the
uevelopment of specific highei valueauu inuustiies
0nfunueu commitment likely to be financeu by state banks
Continuing emphasis on stateleu investment anu
auuitional haiu infiastiuctuie
Responus to symptoms but ignoies stiuctuial causes
Ciitical neeu foi soft infiastiuctuie i.e. establishment of
iule of law, toleiance of piivate finance, etc.
Penuing tiansition to S
th
geneiation at 18
th
Paity Congiess
in 2u12
Xi }ingping thought to be Bu }intaos likely successoi
Noueiate centiist, stiong ieputation on coiiuption
Rose to piominence laigely uue to success in vaiious ioles in
Fujian anu Zhejiang piovinces
Potentially uestabilizing political uynamic
No guaiantee that cuiient piimacy of a balanceu Stanuing
Committee will iemain unuei next geneiation
Possible that Peoples Libeiation Aimy (PLA) will seek
iepiesentation to ieflect its shifting iole in the state
Iv. Inuustiy & the State
What is the cuiient state of Chinese inuustiy.
Chinas piivatizations in the 9us pioceeueu accoiuing to the bluepiint:
Let go of the small, take holu of the big 1S
th
Paity Congiess, 1997
Bictateu by pooi peifoimance of state inuustiy
Bivesteu smallei, inefficient S0Es, concentiateu on iestiuctuieu national champions
1
:
Small S0Es ~2u% of sectoi in 97 but compiiseu majoiity of opeiating losses
Small S0Es piivatizeu, laiu off Su4umm woikeis to enhance piofitability
Suiviving S0Es given tax anu uebt ielief, impoit licenses, access to uomestic anu foieign listing
facilities, anu ieuuceu opeiating iestiictions
Policy of 2 uuaiantees
2
uuaianteeu access to financing anu iaw mateiials foi 2S4 S0Es
Stiongly limiteu neeu to iemain competitive
Not a tiue piivatization:
Restiuctuiing useu to soliuify state contiol anu enhance piofitability of iemaining S0Es
Paity ietains equity owneiship, contiol via coipoiate boaius anu peisonnel appointments
Significant social welfaie consequences
1,2 Huang(2008)
Piivate sectoi significantly smallei than heauline figuies woulu suggest:
0fficial uefinitions aie pioblematic:
Nonstate incluues many collective enteipiises contiolleu by local goveinments
Najoiity of listeu S0Es aie classifieu as nonpublic:
Bowevei, state ietains majoiity owneiship anu contiol of coipoiate boaius
2uuS 0ECB stuuy suggests piivate sectoi is ~7u% of economy
1
Confusion iegaiuing legalpeison shaieholuing fiims (~4u% of piivate sectoi)
0ECB views as piivate, but majoiity of legalpeison fiims aie owneu by state anu uiiectly
supeiviseu by state council:
0ECB list incluues subs. of iecognizeu S0Es like PetioChina anu China National Petioleum
Coipoiation as well as state champions like SAIC Notoi
7S% have zeio inuiviuual shaie capital, 4S% aie meiely piouuction subsiuiaiies of othei
S0Es
2
Coiiecting foi this, tiue piivate sectoi is only aiounu 4u% of economy
2
Even if we accept the 7u% numbei at face value, shaie is still low:
Compaiable to Inuiia uhanuis Inuia with nationalizeu banking system anu the license iaj
Piivate sectoi piimaiily concentiateu in capital extensive seivice sectoi
Reflects iestiicteu access to official souices of financing
1 SeanDougherty&RichardHerd,FastFallingBarriers&GrowingConcentration:TheEmergenceofaPrivateEconomyinChina, OECDEconomicsDepartmentWorkingPapers 471(2005)
2 Huang(2008)
3 Ibid,p.124
Najoiity of listeu cos. aie stateowneu:
0nly 7% of 199u2uuS listings fiom piivate cos.
1
State sectoi given piefeiential access to capital maikets
Nost competitive of tiuly piivate companies iemain piivate, BKuomicileu
Nany of these national champions uiu not exist befoie theii public listings
Westein investment bankeis facilitateu cieation of national champions as pait of
iestiuctuiingconsoliuation of S0Es uuiing late 9us
2
Exemplifies paitys oppoitunistic use of maiket institutions to achieve policy goals
China Nobile paiticulaily egiegious example
S
:
Cieateu by iolling up assoitment of pooily manageu piovincial telcos. aftei 1997 IP0
Pioceeus fiom NYSE listing supplementeu with bank loans, useu to puichase telcos. in
6 piovinces owneu by its own paient
Piospectus iefeiieu to a piofoima entity not yet opeiationally integiateu
Followeu by seconuaiy offeiing in 2uuu, pioceeus similaily useu to expanu in a
fuithei 7 piovinces
Weakest public listings backstoppeu by stiategic investois
Stateuominateu financials, financial subsiuiaiies of S0Es, anu othei goveinment
entities (ANCs, militaiy inuustiials, etc.) mateiial investois in IP0s
2u1u ABC listing Su% of allocations to stiategics
4
Bighlights otheiwise lukewaim maiket ieception, paitys close involvement
inbackstopping of maiket listings
Paity ietains majoiity owneiship & contiol of boaius
Paity no longei in uiiect contiol, but able to exeit significant influence inuiiectly
1 Huang(2008)
2 Walter&Howie
3 ChinaMobileProspectus(SECFormF3),filed10/04/00
4 Walter&Howie,178181.
1 McGregor(2011),85
uovt. has laigely withuiawn fiom uiiect
management but asseits equity owneiship
inuiiectly via peisonnel appointments:
2 piimaiy leveis to contiol appointments:
Cential 0iganization Bepaitment (C0B)
Chinas state Buman Resouices oiganization
Bictates all meaningful leaueiship appointments
within Paity anu enteipiise system
Thought to contiol 7umm+ jobs
Senioi bank manageis must be appioveu by C0B as
well as PB0C anu special banking committee
Committee on Biscipline Inspection (CBI)
0seu oppoitunistically by centei to contiol
pioblematic local officials
Lacks tiue inuepenuence
overseetheappointmentsofUSstategovernorsandtheirdeputies;themayorsofbigcities;headsoffederalregulatoryagencies;
thechiefexecutivesof GeneralElectric, ExxonMobil, Walmart and50oddoftheremaininglargestcompanies;justicesonthe
SupremeCourt;theeditorsof TheNewYorkTimes, TheWallStreetJournal and TheWashingtonPost,thebossesofthetelevision
networksandcablestations,thepresidentsof Yale andHarvard andotherbiguniversitiesandtheheadsofthinktankssuchas
the BrookingsInstitution andthe HeritageFoundation.
1
A hypothetical Ameiican equivalent of the C0B woulu:
TheCODsdiscrete,featurelessBeijing
headquarterslacksanysignage
1 TheodorGroves,Yongmiao Hong,JohnMcMillan,andBarryNaughton,ChinasEvolvingManagerialLaborMarket,JourneyofPoliticalEconomy 103(4)87392(1995)
Executives at S0Es aie fiequently iotateu between
posts at the C0Bs behest:
Aveiage S0E executive tenuie S.S yeais
1
Peisonnel tiansfeis contiavene coipoiate goveinance
iequiiements of public listings
Wheie paity anu inuustiy inteisect, legal obstacles aie
meie foimalities
Selectedpersonnelappointmentssince2000:
China Nobile, China 0nicom, & China Telecom
CE0s switcheu places without waining to bieak up
emeiging centeis of powei
Beaus of S aiilines iotateu to ieuuce piice competition
vicegov. of PB0C maue CE0 of China Constiuction
Bank
As if }anet Yellen was given }amie Bimons job
CN00Cs chaiiman appointeu goveinoi of Bainan
Chaiiman of Buaneng Powei maue uep. gov. of Shanxi
Chaiiman of Chinalco electeu to cabinet auvisoiy post
S4 of 1uu+ S0Es on cential nomenklatuia list
1
ChaiimanCE0s holu ministeiial iank anu selecteu by C0B
Less poweiful State0wneu Asset Supeivision & Auministiation
Commission (SASAC) selects CF0svPs
Especially influential in Big 4 banks
Paity Committees foimeu within laige companies to insuie
political coiiectnesspolicy implementation
Committees active even in foieign businesses }vs
Sleepei cells intiouuceu postTiananmen to be activateu uuiing ciises
Politicization of management cieates pioblematic
conflicts:
Can a bank managei iefuse a loan to an executive with gieatei
stanuing in the paity.
No
S0Es useu to piopup failing cos. via stiategic investment
2
China Nobile Puichaseu 2u% of Shanghai Puuong Bevleopment Bank foi $S.8bn
China 0nicom Rumoieu to have investeu in BoComvia opaque subsiuiaiy
Niiiois S0E backstopping of otheiwise thinly subsciibeu equity offeiings
The Reu Nachine
Top executives at laigest S0Es iepoiteuly ieceive an enciypteu 4uigit
telephone line (the socalleu Reu Nachine)
S
Communications link between paity elite
Symbolic of symbiotic statebig business ielationship
1 Walter&Howie,169
2 Walter&Howie,192
3 McGregor(2010),78
Theultimatestatussymbol?
Zhongnanhai,theChineseKremlin
Source:WorldBank,Bloomberg
ReflectsROEofNikkei225,DAX,CAC40,HangSeng ChinaEnterprises,KOSPI,MICEX,FTSE100,BOVESPA,SENSEX,IBEX35,S&P100,JakartaCompositefirms,exfinancials.
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%
3

Y
e
a
r

A
v
e
r
a
g
e

G
D
P

G
r
o
w
t
h
3 Year Avg. Return on Equity
Bespite significantly highei uBP giowth Chinese fiims lag emeiging maiket peeis
as well as some uevelopeu maikets in ietuin on equity
1 Madar,Daniel,BigSteel:Technology,TradeandSurvivalinaGlobalMarket,(Vancouver:UBCPress,2009)116.Assumesminimumefficientscaleat5mmt(conservative)
2 WorldSteelAssociation
Chinas steel inuustiy is inuicative of the uangeis of
the state contiolling enteipiise:
Inuustiy uemanus scale but fiagmentation incieasing:
Top S piouuceis 1S
iu
in 88, only 1S
th
in u8
Contiasts with global consoliuation tienu
Fiagmentation uiiven by meuuling of local officials
Bighly fiagmenteu anu inefficient
Economies of scale limiteu uue to state piice contiols
Estimateu that only u.S% of Chinese steel mills aie of
efficient scale
1
Suiplus capacity anu continuing iiiational giowth
Capacity > E0 + }apan + Russia + 0S combineu
2
Significant iule capacity
0nly >S% of steel expoiteu
Pieuominantly lowgiaue long piouucts
Limiteu valueauu, must impoit highei giaue flat
piouucts
Inefficient inuustiy aiueu anu abetteu by
peivasive accounting fiauu:
99% of S0Es have falsifieu accounts to some
extent
1
Sloppy uue uiligence, weak uisclosuie,
limiteu sciutiny by unueiwiiteis
Regulatoiy iepoit issueu in late Naich
ciiticizeu 17 banks foi listing piactices
Recent fiauus unnoticeu by highpiofile
auuitois anu investois in the west (Long
Top, China Neuia Expiess, SinoFoiest, etc.)
Reflective of unuue Westein optimism.
Banks complicit in fiauus
Cash holuings significantly oveistateu by
coipoiates biazen, easily falsifiable
misiepiesentations
17 S0Es have aumitteu to misiepoiting
financial uata in 2u11
2
Bong Kong Stock Exchange accepts
Chinese auuitois as of late 2uu9
Chinesefraudshavepassedmusterwithsomeofthe
Westsmostrespectedauditorsandexchanges
1 Shih(2007),175,GordonChang,TheComingCollapseofChina (NewYork:RandomHouse,2001)
2 JamesGrant,GrantsInterestRateObserver,6/3/2011,NationalAuditOffice.
1 NewYorkTimesDealbook ChineseReverseMergerCompaniesDrawLawsuits,7/26/11.Accessed8/23/11,http://dealbook.nytimes.com/2011/07/26/chinesereversemergercompaniesdrawlawsuits/
0.00
0.50
1.00
1.50
2.00
2.50
3.00
Chinese Rev.
Merger Index
Russell 2000
TheInfamousChineseReverseMerger
Peivasive accounting fiauu in 0Slisteu Chinese stocks
Exchanges have halteu tiauing penuing outcome of SEC investigations
Accounteu foi almost Su% of feueial secuiities classaction lawsuits in 2u11 YTB
1
Lax accounting stanuaius facilitate a laige maiket foi off
balance sheet finance:
Entiusteu Loans
Coipoiatehouseholu uepositois contiibute funus to tiusts manageu by bank
Pioceeus loaneu to S
iu
paity boiioweis
Ciicumvents inteiest iate caps anu lenuing quotas imposeu on banks
Bank eainings incieasingly uiiven by off balance sheet
vehicles
Entiusteu 0BS loans est. at ~8% of all lenuing in 2u1u
1
0BS loans up 11u% YoY in 2u11
2
Repoiteuly 4u% of entiusteu loans go to piopeity uevelopeis
S
Figuies iepiesent only officially iecognizeu 0BS vehicles
Bogus Tiaue Finance
Phony invoices iepoiteuly useu to impoit physical commouity
assets that can be leveieu
Favoieu by piopeity uevelopeis maxeu out in abovegiounu
uomesticoffshoie maikets
Also useu to ciicumvent capital contiols
Coppei favoieu pieviously, Soy incieasingly populai
Enoimous contingent liabilities
0nuiawn cieuit commitments at Big 4 RNB 7.4 tin 18%of
GDP!
4
Loandocs.fora36mo.entrustedloan
forRMB300mmtermloanwithRMB
3,000mmrevolverfortheconstructionof
acoalgasificationplant.
1 PBOC
2,3 HenrySanderson,OffBalanceSheetLoansDouble,BoostingBankDefaultRisk,BloombergNews,6/23/11,Accessed8/23/11.http://www.bloomberg.com/news/20110623/offbalancesheetloansdoubleboostingbankdefaultriskchinacredit.html
4 JamesGrant,GrantsInterestRateObserver5/20/11.
v. Stiuctuial vulneiabilities
Coipoiate cieativity in accounting
is miiioieu in official goveinment
accounts:
uovt. economic figuies aie foi
iefeience only
Li Keqiang (), heii appaient to
Wen }iabao, Chinas ieigning technociat
0fficial govt. uebt RNB 6.S tin
ANC piogiam anu othei measuies ieflect explicit intention to minimize stateu uebts
1
uoveinment has significantOBSdebts(2u1uE):
0nfunueu N0F ieceivables anu steiilization bills RNB 2.6 tin
ANC uebts, 2uuS2uuS RNB 2.7 tin
Nonconsoliuateu uebt of State Ninistiies RNB ~4uubn
Nonconsoliuateu local govts. (laigely u8u9 vintage) RNB ~1u tin
Policy bank uebt RNB 4.S tin
uovt. ietains ultimate iesponsibility foi state financial system
uovt. 0BS uebt likely S4x officially uiscloseu uebts = total uebt: ~1uu+% of uBP
2
1 Shih(2007)171
2 VictorShih,LoomingProblemofLocalDebtinChina.AsianWallStreetJournal,2/10/10.
Consensus view: uovt. can iecap. financial system
with enoimous foieign exchange ieseives
Reality: Bebts vastly unueistateu, ability to ueploy
foiex ieseives uomestically is limiteu
Investing foiex ieseives uomestically woulu unwinu
liquiuity oveihang on PB0C balance sheet
Poition of ieseives alieauy investeu uomestically,
incluuing holuings of bank equity
Suggests only a fiaction of ieseives coulu be
quickly ueployeu to iecapitalize the banking
system aiiest an evolving systemic ciisis
Chinas fiscal position is a complex web of off
balance sheet entities anu unfunueu commitments
Beauline uebtuBP giossly unueistates liabilities
State enteipiise system ue facto liability of the state
0ltimate liabilities of Chinese state
aie wholly unknowable
Enoimous inequality concentiates wealth
1% of Chinese householus (u.4% of population)
contiol upwaius of $SS tiillion uepenuing on
assumptions
1
Reallocating Su4u% of this wealth oveiseas woulu
uiain majoiity of uomestic ieseives
2
Negative ueposit iates anu limiteu channels foi
uomestic investment piomote capital flight
Weakening ietuins on uomestic equities, ieal estate
shoulu acceleiate capital flight
Capital contiols aie poious, paiticulaily foi wealthy
anu politically connecteu
0nueigiounu banks moneychangeis
Bogus tiaue invoicing
Incieasing cuiiency libeialization
Eviuence suggests capital flight is alieauy unueiway
Incieasing investment by Chinese nationals oveiseas
Real estate in 0S, Canaua, Singapoie, Austialia, etc.
1,2 VictorShihHighWealthConcentration,PorousExchangeControl,andShockstoRelativeReturn:TheFragileStateofChinasForeignExchangeReserve.PresentationattheInstituteofNewEconomicThinking,Bretton Woods,NH04/09/11
2 CNTV,ChinesePeopleInvestMoreinRealEstateAbroad.4/11/2011,accessed8/23/11.http://www.china.org.cn/video/201104/11/content_22330861.htm
USrealestatebrokerscourtingChineseinvestors
Chinesebuyersaccountedforalmost11%ofUSreal
estatetransactionsin2011
3
vI. Conclusion
While piogiess has been maue, China effectively
iemains a commanu anu contiol economy at heait:
No moie cential planneis, but paity uistoits most
ciitical maiket piicesmechanisms
A China bull must believe in stateleu capital
allocation anu that it can be successful on a scale
unpieceuenteu in human histoiy
Libeialization is meaningless without:
Piivate owneiship
Piivate capital allocation
Rule of law
Bow is this uiffeient fiom the olu uays.
China is moie iauical |The State] wants to leau eveiything.
This is the gieatest uiffeience
Yuan Weishi, Zhongshan 0niveisity
1
1 McGregor(2010)78.
2 CIA
Is Chinas iesilient giowth suipiising
given that it is piimaiily uiiven by
goveinment financeu investment.
Pieceuent: The Soviet 0nion manageu the
same feat in the Sus (~7% compounu
giowth) by boosting investment spenuing
2
As If All This Wasnt Enough
Chinas uemogiaphic uiviuenu is fauing:
Population of woiking age piojecteu to shiink at u.1% pa fiom 2u1S2u2S
1
Significant ieveisal of pieviously benign uemogiaphic tienus
0ne chilu policy has cieateu genuei imbalance
117:1uu malefemale iatio in 2u1u 4u mm moie men than women by 2u2u
2
Incieasing social uniest
8u,uuu mass inciuents in u7, up fiom 6u,uuu in u6
No iecent official uata but leakeu uata suggests as many as 12S,uuu inciuents in u8
S
Recent suige of inciuences incluuing suiciue bombings
Bas leu to incieasingly violent ciackuowns
Baiassment of foieign jouinalists, aiiests of intellectuals anu activists,
iesuigence of Naoism
4
State has incieaseu allocation to state secuiity 14% in latest buuget
S
1 UNPopulationDivision,StandardChartered,TheEconomist.
2 ChinaFearsBachelorFuture.BBCNewsOnline,4/5/2004.
3 WaveofUnrestRocksChina.TheWallStreetJournal,6/14/2011.
4 Princelings andtheGoonState.TheEconomist,4/14/2011.
5 ChinasSecurityState:TheTruncheonBudget.TheEconomist,5/10/2011.
Lackofconcernforhumanrights
Extensivestatecensorship
Laxenforcementofintellectualproperty
Lackofinnovation
UnauthorizedAppleStoerinKunming
Bow Now Biown (Reu) Cow.
China has befoie it two alteinate paths:
1. Status quo
0nsustainable, unfaii, unbalanceu, anu inflationaiy
System incapable of suiviving slow global giowth enviionment
Inflation will continue to mount, inflame social tensions, anu unueimine paity cieuibility
Sheei scale cieates uppei bounu to capitaliesouice intensive giowth mouel
Bebt financeu giowth + pooi capital allocation + low iecoveiy iates + unueistateu
inflation = iecent economic giowth is likely oveistateu & peihaps altogethei illusoiy
2. Stiuctuial iefoim
Refoims iequiieu aie inheiently longteim unlikely to ease immeuiate piessuies
Woulu iequiie paity to uiastically ieshape ielationship to state anu enteipiise
Significant ielinquishment of powei & effective aumission of failuie by CCP
Significant impeuiments:
Bepenuency on uomestic savings foi financing
Funuamentally uncompetitive inuustiy
Entiencheu politicalbuieauciatic incumbents inhibit iapiueffective iefoim
0niesolveu liquiuity oveihang on PB0C balance sheet
Significant human capital ueficit fiom chionic social unueiinvestment
Nounting pile of uniesolveu bau uebts stietching ~2u yeais
Acknowleugements
I woulu like to ueuicate this piesentation to the
couiageous effoits of Chinas piivate sectoi business men
anu women, who have fiequently peiseveieu uespite the best
effoits of the coiiupt, aiiogant, anu iepiessive iegime of the
Communist Paity.
This uocument owes a significant intellectual uebt to the
woik of many but I woulu like to especially iecognize the
contiibution of the following scholais:
Caison Block
}ames uiant
Fiasei Bowie
Yasheng Buang
victoi Shih
Cail Waltei
Bali Yang