communism comes of age

8/4/2019 Communism Comes of Age

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IMPORTANT DISCLAIMER:

THE FOLLOWING PRESENTATION REPRESENTS MY PERSONAL OPINIONS

AND DOES NOT REPRESENT A COMPRHENSIVE ANALYSIS OF THECHINESE ECONOMY. ALTHOUGH THE INFORMATION CONTAINED HASBEEN OBTAINED FROM SOURCES BELIEVED TO BE ACCURATE I CANNOTGUARANTEE ITS ACCURACY, COMPLETENESS, OR FAIRNESS. OPINIONSINVOLVE NUMEROUS ASSUMPTIONS WHICH MAY OR MAY NOT PROVEVALID AND WHICH MAY BE CHANGED WITHOUT NOTICE.

THIS PRESENTATION IS INTENDED FOR INFORMATION PURPOSES ONLYAND DOES NOT CONSTITUE INVESTMENT ADVICE, A RECOMMENDATION,

SOLICITATION, OR OFFER AND IS NOT THE BASIS FOR ANY CONTRACT TOPURCHASE OR SELL ANY SECURITY OR OTHER INSTRUMENT.

I, AS WELL AS PERSONS ASSOCIATED WITH MYSELF, MAY MAINTAIN

POSITIONS IN SECURITIES, INSTRUMENTS, AND/OR MARKETS REFERREDTO BY THIS PRESENTATION.

Questions, comments, and all other inquiries should be directed [email protected]


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Macroeconomic Review Growth Drivers

Monetary Policy & the Currency

Social Implications

Banking & Finance Corporate Finance

Regulatory & Market Structure

Party & State Overview of Political System

A Brief History of Reform

Industry & the State

Structural Vulnerabilities

Summary & Conclusion

Ren Xiong (1823-1857)LateQingdynastypainterofthe

Shanghaischool


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I. Macroeconomic Review


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Since reform began in 1978, China hasachieved spectacular growth:

9.8% annual growth since 1978

Worlds 2nd largest economy in 2010 Worlds 18th largest economy in 1978

IMF predicts:

China GDP USA GDP by 2016 PPP

Notable divergence from developedworld in 20082009

Consensus view

Gradualist school

China is incrementally converging withWestern economic and political norms

China will overtake the US as globalconsumer and economic leader


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In billions of USDSource: IMF

GDP

Chinas growth record is impressive, even when compared to otheremerging markets:

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


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How has this been achieved 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

Chinas

Share

of

World

GDP

1978-

2010

Howhas

China

gone

from

being

an

economic

backwater

to

threateningAmericansupremacyinjust30years?


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How does China manage this seemingly impossible balance?

Weaddresseachofthesepointsinturnbeforereviewing

Chinasfinancial

and

political

economy:

Maintain weak renminbi RMBto preserve export competitiveness

Restrain inflation

Achieve consistent growth

78% explicit target


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Chinese macroeconomic policy attempts tobalance:

Open capital account

Necessitated by reliance on trade Porous capital controls Open to foreign direct investment (FDI) withlimited portfolio flows

Fixed exchange rateManaged peg to USD

Independentmonetary policy

Theory suggests this is impossible

1,2,3

The Impossible Trinity

This balance has been achieved by the statescoercive power and its dominance of domestic

markets

1 R.A.Mundell,CapitalMobilityandStabilizationPolicyunderFixedandFlexibleExchangeRates,CanadianJournalofEconomics&PoliticalScience29(1963)2 M.J.Fleming,DomesticFinancialPoliciesunderFixedandFloatingExchangeRates,InternationalMonetaryFundStaffPapers 9(1962)3 A.Rose,ExchangeRateVolatility,MonetaryPolicy,andCapitalMobility:EmpiricalEvidenceontheHolyTrinity,NBERWorkingPaper4630(1994)


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Having Your Cake

Exports subsidized by central bank, the Peoples Bank of China (PBOC) Monetary authority, acts in broadly similar fashion to developedmarket central banks

Normally, Chinas persistent trade surplus would cause the renminbi

(RMB) to strengthen against the dollar (USD):

The PBOC prevents the trade balance from adjusting byintervening in FX markets to maintain the weak RMB

Prints RMB to buy dollars in open market operations Transacted as much as $1.8 bn/day in 2007!1

Inherently inflationary; impact must be compensated for

Impact sterilized by removing currency from circulation

9705 China formally peggedRMB against USD

0508 Managed float allowsfor ~20% appreciation

08 Present Defacto USD peg@ ~6.80 RMB/USD globalslowdown calls for halt to

appreciation

A Brief History ofChinese Currency

Manipulation

1 J.Greenwood.TheCostsandImplicationsofPBOCSterilization,CatoJournalVol.28,No.2(2008)

Sterilization causes significant local andinternational economic distortions

Sterilization

can

only

postpone

inevitable

adjustments


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and Eating It Too

The mechanics of sterilization:

Chinese exporters receive USD from American buyers Exporters sell USD to PBOC Exporter receives newly created RMB from

Printing RMB offsets natural adjustment

PBOC accumulates USD reserves, RMB supply

Newlyprinted RMB must be sterilized:

USD used to purchase foreign assets: Largely parked in US Treasuries

No sufficiently large/liquid alternatives Reserves deployed increasingly aggressively via

sovereign wealth funds etc.

Asset purchases augmented by financial repression: Necessary to minimize leveraged effect of RMBcreation through fractional reserve banking

A Brief History of ChineseCurrency Manipulation


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Free from the rule of law, China has used financialrepression to limit the inflationary impact ofperpetual money printing:

PBOC sets deposit and lending rates artificially

PBOC imposes lending quotas on banks

PBOC issues ST notes and Special Bills to banks

Low yielding bonds forced upon banks to immobilizebank assets below market coupons De facto increase of bank reserve requirements 5.1% of domestic assets at 12/31/101

Bank reserve requirements 23.5% of domestic assets at 12/31/102

~30%ofbankcapitalimmobilized

Inflationary pressures continue nonetheless

1,2 PBOC 2010AnnualReport,ChinaBankingRegulatoryCommission


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Chinahasmadecappingpricerisesthepriorityofmacro-economicregulationandintroducedahostof

targetedpolicies.

These

have

worked.

We

are

confident

price

rises

will

be

firmly

under

control

this

year.

Wen Jiabao (), 6/23/11 Financial Times editorial

Official figures understate true market rates anecdotal evidence of rates in shadow bankingsystem >20% in 2011

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 3Mo.

DepositRate 3 Mo.

CPI, YoY

PPI, YoY


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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

US & Chinese Monetary Aggregates

A sight to humble even Helicopter Ben

Source: Federal Reserve, PBOC

Massivefiscalstimulus 14%ofGDP!(USstimulus 6%)

The PBOCs perpetual money printing calls into question demandbased estimates of the value

of Chinese currency Chinahas

agreater

money

stock

than

the

US


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Explicit costs of sterilization:

Spread between costs of special bills and return onforeign assets Size of special bills relative to size of foreign assets

1 PBOCStatistics&Figures2010

Implicit costs of sterilization: Lending shifts to shadow banking system

Off balance sheet leverage andunderground banking system

Distorts capital allocation PBOC balance sheet expansion crowds outconsumption

Balance sheet must grow with economy tomaintain peg 12/31/10 PBOC is levered 1,180x!1

Inflation can only be suppressed temporarily:

Liquidity overhang remains on PBOCbalance sheet Significant obstacle to deploying reservesdomestically

Ultimate adjustment filters through via: Domestic prices

Export sector via resource procurement Significant buyer of commodities

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 USDSource: China Economic Information Network, Bloomberg

ForeignExchangeReserves 1999-2011

CurrentPBOCGovernorZhouXiaochuan ()

At 6/31/11 Chinas reserves were:3.4x 2005reserves

17.7x 2001reserves


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Raising interest rates last resort for PBOC to control inflation: Raises costs of currency sterilization deposit rate +1% costs +~5% 1

Attracts speculative capital flows (hot money) Inflicts losses on banking sector via bond holdings

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

HouseholdSavingsDeposits 1Yr. Rate

China 1 Yr.LendingRate

DepositReserveRatio

1 Christer Ljungwall,Christer,YiXiong,andZou Yutong. CentralBankFinancialStrengthandtheCostofSterilizationinChina. CERCWorkingPaper8(2009)

Source: PBOC, Bloomberg


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Mercantilist trade policy/sterilization has led China to share Japans burden ofunderwriting American profligacy China is a forced buyer:

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 byForeigners

US Debt to China

US Debt toJapan

China, % of Tot.

Japan, % of Tot.


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China is ~10% of World GDP but its share of global commodity consumption ismuch higher:

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 resourceintensive growth is stretching global supplyFurther growth will prove increasingly costly and pressure domestic prices


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-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

Previous inflationary surges (late 80s, mid 90s) managed by extraordinary financialrepression

Total halt of bank lending, sweeping centralization of finance/fiscal authority, etc. Achieved by powerful core leaders (i.e. Deng Xiaoping, Zhu Rhongji, etc.)

Unclear if current bureaucratized apparatus is capable of repeating such drastic action


ChineseConsumerPriceIndices 1978-1998


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Like Asian peers, China has utilized the exportgrowth model:

Arbitrage advantage from low cost labor

2035%/GDP from exports

Ultimate impact is larger:

Proceeds are levered through statefinancial system & reinvesteddomestically

4050% of GDP from fixed assetinvestment

Primary destinations for fixed assetinvestment1:

Export production capacity

Real estate

Significant leverage to global demand

Investment increasingly compensating for weakglobal demand:

~70% of 2008 growth

~90% of 2009 growth2

1 MoodysAnalyticsReportChina:FixedAssetInvestment. Published6/13/2011.

2 PivotCapitalManagementReport ChinasInvestmentBoom:TheGreatLeapintotheUnknown(2011),NationalBureauofStatistics


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Exports & Gross Capital Formation / GDP 1981 2009

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1981 1986 1991 1996 2001 2006

Gross Cap.Form. (FixedAssetInvestment)

Exports

Combined

Globaldownturnliterallypavedover:

Source: World Bank


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1 HSBCGlobalResearchCurrencyWeekly,06/07/2010, p.5

2 PivotCapitalManagementReport ChinasInvestmentBoom:TheGreatLeapintotheUnknown(2011),p.7. Chartsexcerptedfromsamereport.

Real estate is another significant destination for fixed asset investment:

HSBC estimates total value of residential property at 3.27x GDP1

Almost2xlevelinUSbeforesubprimecrisis ClosetoJapanesepeaklevelof3.8x

Japanese 89 GDP/Capita = 14.4x China 09 GDP/Capita (Constant USD)

Price/income levels top global markets at peak of credit cycle

Price/Income 1520x in major cities, ~10x in regional cities2

9x in London, 12x in Los Angeles in 2007


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Compensating for Something? More than 100 supertall ( >300m) buildings in planning or under construction

Currently only 70 buildings > 300m globally Significant number of projects financed and initiated by local governments Historically, projects of this scale have marked market tops1:

PingAnInsurancesnewShenzen

headquarters 115floors,648m under

construction

Goldin Finance117,Tianjin 117

floors,597m underconstruction.

Masterplanalsocallsfor270story

towersand

residential

high

-rises

1 AndrewLawrence, TheSkyscraperIndex:FaultyTowers,PropertyReportDresdnerKleinwortWassersteinResearch (1999)

TheGuangzhouUrbanPlanningBureaus

proposedcenterpiecefortheplannedBaietan

CBD 118floors,650+m. Thedistrictwill

havemore

than

10mm

sq.

meters

of

floor

space.

ForthebenefitofAmericanreaders,Chicagos Willis(Sears)Towerisonly527mwhenits85mantennaeareincluded


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Dubai X 1000?

Tianjin is planning an especially grandiose central business district which is currentlyunder construction:

Construction of Phase 1 of project is underway The towering building visible at center left is to be ~600m,which would be the worlds second tallest if it stood today


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China is in dire need of structural reform: Dependent on export economy & fixed asset investment

Export impact smaller on a net basis, but provides critical

source of foreign exchange

Macroeconomic management distorting capital allocation

Mounting leverage and inflation

Party remains dominant player in business and finance

Utilizes market mechanisms selectively & on its own terms

Unwilling to relinquish meaningful authority to markets

1 BarryEichengreen,Donghyun Park,&Kwanho Shin.WhenFastGrowingEconomiesSlowDown:InternationalEvidenceandImplications forChina,

NBERWorkingPaper16919(2011)4

Experience of other Asian tigers suggests growth will slow irrespective of internal obstacles1

Middle Income Trap export model has limitations Export & invest model precludes balanced growth & formation of consumer society

TemptingcomparisonstoJapanbutrealities

ofChinaareevenstarker


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Consensus: China will rebalance and replace US as globalconsumer McKinsey Chinese urban middle class with spending power equivalent to

Japanese households by 2025 $2.4 trn

Problems recognized, but structural transition taken as a given

Reality: China become a consumer nation withoutsignificant Govt. recognizes problems but wedded to statist solutions

Soft infrastructure needed, not more hard infrastructure

Current system incompatible with consumer society

State must withdraw from capital allocation State investment crowds out private entrepreneurs

Investment funded by state banking system, in turn funded bycaptive capital of private savers

Nonstate sector starved of capital and resources

Capital markets play no meaningful role in capital allocation

PBOC must curtail its market operations Massive balance sheet expansion crowds out domestic

consumption, creates dangerous liquidity overhang

Dividends from export subsidies accrue largely to foreigninvestors and stateowned enterprise


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Populace has not shared in gains from growth:

Personal income/ capita severely lags GDP/Capitagrowth, which itself lags GDP growth1

Wage squeeze worsened by inflation/asset bubbles

2nd largest economy, but 93rd in GDP/Capita IMF Between Macedonia (92nd) & Algeria (94th)

GDP/Capita overstates income as only ~40% flowsthrough to labor

Labors slice of the pie is shrinking2:

1997 Wages/GDP: 53% 2007 Wages/GDP: 40%

Large wealth inequality

0.4% of Chinese control 4050% of wealth3

Gini coefficient: 47 in 2010 according to state ests.4

Understated, excludes hidden income

Concentration of wealth reflects concentration ofpower amongst political elites

How successful can the Chinese miracle be when

so few have enjoyed 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,TheChinaQuarterly154(1998)2 RichardMcGregor,TheParty(NewYork:HarperMacMillan) 20103 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/2010 05/12/content_9837073.htm


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Since the early 90s, Chinas urban populace has been favored at theexpense of their poorer, less educated rural compatriots:

Per capita income1:

Urban $2,000

Rural $ 605

Limited job opps. 40% of rural population un or underemployed2

Limited public services in rural areas

Cut off from bank credit, reliant on informal credit/loan sharks

Function of concentration of wealth/political power in cities

Huoku) rural/urban class register system exacerbates divide:

Rural citizens literally second class citizens with restricted mobility Creates marginalized class of 150mm migrant rural laborers3

Rural workers can move to cities to seek jobs, but lack access to basicpublic services due to rural citizenship

Often forced to work in informal lowpaying jobs

Social position analogous to illegal immigrants in the US

1 Yasheng Huang,CapitalismwithChineseCharacteristics:EntrepreneurshipandtheState (NewYork:CambridgeUniversityPress,2008)251.2 JasonGale&BretOkeson.ChinaDoctorsEarning$300aMonthFlocktoDrugCompanies, BloombergBusinessweek,7/10/11.3 JohnBryanStarr,UnderstandingChina:AGuidetoChinasEconomy,History,andPoliticalCulture,3rdEdition(NewYork:Hill&Wang,2010)162.4 Ibid,pp.148149.

Privatizations of 90s dismantled Iron Rice Bowl )social security net: SOEs used privatizations to jettison lowproductivity workers at firms thought to be ~30% overstaffed4

Tenured SOE employees had previously enjoyed guaranteed jobs and benefits the Iron Rice Bowl Restructuring carried out to enhance profitability of SOEs retained by government

Created large group of structurally unemployed ~1/2 thought to still remain jobless4

Current government retirement programs available only to urban residents, ~95% funded by local governments 4


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Local governments now responsible for education,healthcare, and social security after late 80s reforms:

Created problematic conflicts for local leaders withsignificant social consequences:

New responsibilities were unfunded mandates Local officials performance still assessed by nominal growth: Incentivized to favor short term economic growth over longterm

social investment

Increasing demands on local leaders paid for through

unsustainable financing practices: Local governments allowed to run budget deficits in 2008 Local government debts already ~25%/GDP by yearend 2009!1

Incentive structure promotes short termism in local finance

Sales of expropriated prop. frequently used to fund budget gaps

Arbitrary seizures of peasant farmland, property resold to

developers by local government 70mm farmers have lost their land in this way in the past decade!2

Aggrieved citizens have little recourse as local governmentsword is law: Seeking justice higher up the state hierarchy difficult and dangerous

1% of petitions for redress to government resolved satisfactorily3

1 AnthonyChanChinasHiddenDomesticPublicDebt:SomePerspectiveontheRisksitPoses,AllianceBernstein GlobalEconomicResearchReport(2010)2 Starr,176.

3 Ibid,84


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Healthcare 2000 World Health Organization study ranked Chinas

healthcare system 144th globally1

Behind Burundi 143rd, ahead of Mongolia 145th

~40% of sick rural residents did not seek medical care due to

its unaffordability2

~60% of rural residents requiring hospitalization did not seektreatment due to unaffordability2

1 public health professional / 7,000 people US 1/6353

Education State withdrew education funding in 90s Expense dumped on local govts. and subsequently passed on to

parents in form of increasing school fees

Education costs grew faster than CPI by 10% in 90s4

Inequality continues to rise:5

Lack of training drives inequality in wages6

Illiteracy increased 64.3% between 2000 and 2005

Equivalent to 30% of rural school cohorts from 1990s7

Rural secondary school dropout rates 43% in 00038

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:SomeEvidence fromChina,AppliedEconomicsLetters,8,(2001)7 Huang,43

8 Ibid,248

Patientsawaitingtreatment


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II. Banking & Finance


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Chinese finance speaks to the fundamentally poorprospects for structural transition without reform:

Chinas growth is largely internally financed

FDI is limited & largely focused on export industries

i.e. offshoring/outsourcing

High savings rate finances investment glut Savers unwillingly underwrite growth

Banking sector provides cheap capital for SOEs, local govts.

State sets interest rates and limits investmentoptions for savers

Fixed deposit rates, fixed lending rates

Creates cheap, captive capital for state banks

Real deposit rates frequently negative

De facto

Alternatives for savers restricted to stocks, RE

Encourages speculation, distorts asset prices Shifts investment to unregulated shadow

banking system


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0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

1982 1987 1992 1997 2002 2007

FDI, % ofGDP

Grosssavings, %of GDP



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1 Walter&Howie,44;YangKaisheng,SeveralThoughtsaboutStabilizingtheCapitalAdequacyofourCommercial Banks,21st CenturyBusinessHerald,04/13/2010

Inourcountryscurrentlevelof

macroeconomicdevelopment,wemust

maintainalevelofmacroeconomic

growthof

around

8%

per

annum

and

thiswillinevitablyrequirea

correspondinglevelofcapital

investment.

Ourcountrys

financial

systemisprimarilycharacterizedby

indirectfinancing(viabanks);the

scaleofdirectfinancing(viacapital

markets)is

limited.

YangKaisheng (),CEOof

Industrial&CommercialBankofChina1


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1 Saez,Lawrence,BankingReforminChinaandIndia, (NewYork:PalgraveMacmillan, 2004)

2 CarlWalter&FrasierHowie, RedCapitalism:TheFragileFinancialFoundationofChinasExtraordinaryRise, (NewYork:JohnWiley&Sons,2011)

CapitalRaising

Activity

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 subsidized domestic banking system finances almost all economic activity1:

Bank loans & bonds account for 1

Equity financing immaterial Foreign banks 2% of financial assets2

Keeps capital market exposure to a minimum


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1 Walter&Howie,86.

Chinas reliance on its state banking systemis understated as corporate bonds are

:

70% held to maturity by state banks1

22 of 24 primary dealers are state banks1 Underwriting bond and retainingcredit risk effectively a loan

The Chinese yield curve is a construction ofthe state:

Uses stateset bank 1 year depositrate as abaseline Trading volume is insignificant yield curvecan be drawn arbitrarily

Bonds issued and sold primarily to governmentcontrolled entities:

Sold at below market coupons Selling unattractive for holders

Creates losses due to belowmarket issuance; politically unappealing

Illustrative of Partys superficial adoption of market institutions:

Structure adopted to maximize partys ability to limit the impact of market forces Institutional character informed by earlier experiences with retail bond market


37/91

The banking system is Chinas de facto second treasury:

Capital allocation system fundamentally since 70s

Party views banking system as policy tool and as a vehicle forpersonal enrichment

o Capital is often politically directed and used by localofficials to accomplish the partys economic targets

o

Senior bank officials & SOE managers selected bynomenklaturasystem

o Party retains majority equity ownership & ultimatecontrol


38/91

1 Bankannualreports,various,PBOC AnnualSurvey&Statistics2010.

Corporate banking in China is dominated by 4 large

statecontrolled banks The Big 4 and their emergingrival BoCom:

Primary tools of state in managing the economy: A second treasury

Despite purported commercialization and publiclistings govt. influence remains significant Credit frequently extended on the basis of personalrelationships rather than perceived creditworthiness

Listed with share of domestic financial assets as of 12/31/101

:

Bank of China BOC 17.0%China Construction Bank CCB 17.6%Industrial & Commercial Bank of China ICBC 21.9%Agricultural Bank of China ABC 16.8%

Bank of Communications BoCom 6.4% Emerging rival to Big 4

Initially formed as state policy banks, later commercialized in early/mid 90s Politicized government. retains majority ownership and controls boards of directors;personnel must be government approved


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1 BankAnnualReports,PBOC.

The core of the banking system is rounded out by theexplicitly statist policy banks:

Listed with share of domestic financial assets as of 12/31/101:

China Development Bank CDB 8.3% Agricultural Development Bank of China ADB 2.8% China ImportExport BankCIE 1.4% China Postal Savings Bank CPSB Undisclosed

Formed in 1994 to take over policy loans from newlycommercialized Big 4 as part of larger fin. sector restructuring

Despite stated mission, majority of activity is indistinguishablefrom operations of commercialized Big 4

ChinaDevelopmentBank(CDB)

Particularly important in recent years:

Led by Revolutionary princeling son ofChinas former supreme state planner , Chen Yun

Lendingvol.onparwithMinistryofFinance 12/31/2010loanbook2XWorldBanks

Sovereign wealth fund, but majority ofinvestment is domestic

70% funded by commercial banks (Big 4)

Shift to universal bank strategy has led statecompetitors to similarly diversify business lines

Introduced new securitized productsExemplifies expansion and ambition of statecontrolled financials

Financier of state ego projects Three Gorges Dam, Shanghai Pudong Aiport,Beijing Olympic projects, etc.

Policy Banks ex. CPSB

Big 4 BOCOM Policy Banks ex. CPSB

Concentration has increased in past decade Centralization of finance aids and abets party control

Ifitdoesnthaveaccesstoastableandsufficientsourceofcapital,theChinaDevelopmentBankwillbe

unableto

operate

normally

Anonymous, Treasury Department, CDB. Quoted 01/11/10 in TheEconomicObserver()


40/91

5- Year Asset CAGR ROARE Loans /Total Loans

OBSCommitments/ Total Loans

NPLRatio

Tier 1Capital

CommercialB

anks 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 & CommercialBank of China 15.8% 1.3% 27.0% 54.3% 1.2% 9.7%

PolicyBanks China Development Bank 21.9% 0.8% N/A N/A 0.6% N/A

Agricultural DevelopmentBank 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 asof 12/31/10


41/91

With aggressive loan growth and weak cash flow generation, Chinese banking isunusually capital intense and requires constant refreshment.

And yet, >50% of 0510 & 95% of 0710 new equity capital paid in dividends!This oddity is more explicable when we recall that vast majority of bank dividends accrue tothe state

(300,000)

(200,000)

(100,000)

0

100,000

200,000

300,000

400,000

2005 2006 2007 2008 2009 2010

Proceeds fromSale of CommonStock

Dividends Paid

Source: Bloomberg, Bank annual reports

EquityOfferings&DividendPayouts,Big4Banks,2005-2010


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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

Creditis

growing

faster

than

GDP


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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 ofFin. Institutions,YoY (L. Axis)

NPL Ratio (R.Axis)

Loan growth has slowed but remains dangerously high


NPLs appear minimal but are a backwardlooking indicator in a loose credit environment

Stimuluswall:

banks

given

green

light

for

growth:


44/91

Chinas state financial system has historically fared poorly &has an unfortunate track record1:

2 major events since 1978:

Late 80s / Early 90s Provincial governors controlled PBOC branches

Local officials overcook growth 20+% inflation Inflationary spike forced total halt of bank lending Sparked hard landing real estate crash in Hainan

Late 90s / Early 00s Induced by Asian Financial Crisis (AFC)

Unresolved NPLs from previous crisis compounded impactof new wave of bad loans 40% of pre2000 loans bad!2

Govt. response led to current market structure

Historical recoveryratesinthe10-20%range on bad loans Compare to recoveries ~60% at peak of US S&L Crisis

Suggests lack of true profit motive in lending, likelihood of fraud andtheft at the margin Without external shocks (i.e. AFC) state can delay reckoning indefinitely

Incomplete reforms Previous crises resolved by creative accounting topped up with smallinfusions of forex reserves and capital raised from IPOs Perceived success of bank recaps. and subsequent collapse of Westernfinancial system has reduced perceived need for reform

1 VictorShih,Factions&FinanceinChina:EliteConflictandInflation,(NewYork:CambridgeUniversityPress,2007

2 Walter&Howie


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1 ThomasBottini,BankruptcyPerilsinChina:TheGITICTale,MultinationalBusinessReview115(2003)

GITIC Forerunner of todays banking sector? Engaged in practices common in modern Chinese finance i.e. off balancesheet vehicles, growth of noncore business lines, politicized lending First and only Chinese financial allowed to fail

Lender and securities co. effectively controlled by local government

Hong Kong listed subsidiary issued bonds in US Govt. provided comfort letters for GITICs international deals

Explicit assurance that state stood behind the bank Enormous expansion in 90s aided by Western banks

One of Chinas first international players

Went bust in wake of Asian financial crisis January 1999 NPL ratio: 1

Recovery rate: 1

First and only bankruptcy of major Chinese financial:

Assets: $2.6 bn Claims: $5.6 bn $4.7 bn to foreign creditors

International exposure prompted larger concern regarding Chinas solvency Necessitated immediate action and a transparent liquidation process:

Appointed KPMG to build credibility with westerners

GITICSformerheadquarters;3rd tallest

buildinginAsiaattimeofconstruction


46/91

1 Walter&Howie

2 Bottini

Prior to GITIC, the PBOC closed failing banks and made foreign creditors whole: Comparatively small scale of financial sector and limited international exposure allowed govt. to easilysettle the bill PBOC put reflected in bond risk:

8 mos. before collapse, GITIC bonds yielded just 240 bps over Treasuries1

Under banking law, banks were required to register debts to foreigners with govt. Intended to protect foreign creditors; unregistered debt unenforceable GITIC used Hong Kong subsidiaries to hide overseas debts Diversified into wide variety of operating businesses:2

Manufacturing, textiles, hotels, etc. Originally thought to have 66 domestic and 66 overseas subs. and uncovered

Scale of debts led to closures of many trust companies and recentralization of Big 4 under

central governments control

PostGITIC reforms sought to recentralize control over the financial system Not about enhancing capital allocation No intention of allowing truly private banking or floating interest rates


47/91

While the provincial GITIC was allowed tofail, China pursued more innovativesolutions to resolving the banks under thedirect control of the central government in

the late 90s / early 00s

Particularly important to the recapitalizationand underpinning Chinas financial systemare the 4 asset management cos. AMCs:

Chinas4AMCs:Orient,Huarong,GreatWall,andCinda

Bad banks used to remove problem loans from bank balance sheets Created to deal with primarily vintage NPLs that remained from past crises:

Govt. delayed resolution until exogenous shock of AFC demanded action 40% of pre2000 loans nonperforming1

AMCs acquired RMB 2.4trn of bad loans to recapitalize financial system

AMCs funded by PBOC AMCs purchase NPLs at face value 100s on the dollar AMCs resemble developed world bad banks i.e. RTC in US S&L crisis, but critical difference:

Banks received AMC bonds an unfunded receivable into banks Accounting solution; to bad loans

1 Walter&Howie


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Intended as temporary institutions, theAMCs 1999 mandate was renewed in 2009for a further 10 years:

Thinly capitalized; inevitably insolvent Negligible capital base and inflated purchase

price of loans made profitable operationimpossible from the beginning Significant operating expenses exacerbateddearth of loan recoveries ~11% by 051,2

Government has had to provide comfortletters to auditors to assure solvency

More recently the elegant AMC system hasbeen abandoned in favor of direct issuance ofunfunded receivables by the Ministry ofFinance MOF:

Mechanics remain the same; banks receiveunfunded, evergreen IOUs

AMC bonds and subsequent MOF receivables aresignificant state liabilities

figures

1 Shih(2007),174

2 Neina Wang,Thetotalassetsandliabilitiesinthebankingsectorgrowbyapproximately19%Zhongguo Zhengquan Bao (ChinaSecuritiesNews),10/12/05


49/91

AMCs like Cinda haveopportunistically used thelicenses of their seized portfoliocompanies to enter a wide

variety of business lines,significantly expanding beyondtheir original mandate:

Seized operating businesses

continue as going concerns

Employ 12,000 people

Bad banks now diversifiedconglomerates

Operating losses worsen alreadyweak financial position

Cindas subsidiaries span life insurance, P&Cinsurance, securities brokerage, equipment finance,futures trading, investment management, real estateinvestment, trust management, propertydevelopment, construction, and even includeindustrial businesses.

AselectionofsomeofCindas publicallyacknowledgedsubsidiaries


50/91

AMC bonds and later MOFreceivables comprise asignificantportion of theBig 4s capital base:

Big 4 Banks - Big Balance Sheet Holesin 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.

Bonds rolled with AMC mandate

Evergreen NPLs: Oldest underlying loans reportedlydate to late 80s and early 90s Continued presence on bankbalance sheets speaks to kick thecan approach to restructuring

Banking system rests on shakyfoundation of accounting trickery

Investors aware of potential balancesheet holes but believe in PBOC/MOF put

Assumption that state will be ableto replicate GITIC restructuring

Confidenceinthebankingsystemreflectsinvestorconfidenceintheabilityof

thestate

to

recapitalize

financial

system

large

forex reserves

provide

illusory

comfort


51/91

th

The PBOC even has its own bad bank used to hide debts & disguise its probable insolvency:

Created in 2005 in order to remove problem loans from PBOC balance sheet

Funded by Cinda Asset Management Co.

Utilized due to close political ties to PBOC

Opaque, no disclosure on operations as portfolio has not been marketed to outside

investors, in contrast to more transparent 1st

generation AMCs

Official documents suggested Huida was to acquire real estate loans fromHainan/Guangxi and portfolios from the GITIC bankruptcy midlate 90s vintages:

Belief among market participants is that Huida instead acquired the PBOCs original AMC loans

in order to ease pressure on insolvent AMCs1

This would imply a roundtrip investment that would offset and disappear if the entities wereconsolidated

Unaudited, off balance sheet vehicle for PBOC and Cinda

Unlisted and unmentioned on Cindas website; fiscal black hole1

1 Walter&Howie


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State Council

Ministryof

Finance

PBOC

Financial RegulatorySoup (NDRC, CBRC,CSRC, CIRC)

StateOwned AssetsSupervision & Administration

Commission(SASAC)

SOEs

China InvestmentCorp. (CIC)

Central HuijinInvestment

Central SAFEInvestment

Asset ManagementCos. (Huarong, Orient,

Great Wall, Cinda, Huida)

Big 4 and ChinaDevelopment Bank

The Ministry of Finance, operating directly under the State Council, lies at the heart of the contemporary Chinesefinancial system:

The PBOC has been relegated to a secondary role after suffering a significant erosion of its power in the early/mid 00s PBOC formerly controlled Big 4 & CDB via Central SAFE Investment

Divisions between the PBOC & MOF reflect alternate career paths within the party1: MOF dominated by generalists: Typically rotated between ministries and localities

Historically has favored decentralization of financial control, economic growth over price stability/social welfare

PBOC dominated by Technocrats: Typically advanced through silo hierarchy of PBOC

Historically has favored centralization of finance and prioritized price stability

1 Shih(2007)4763


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The current ownership & regulatory structure of Chinas financial systemis the product of stillborn reform:

PBOC led reform and restructuring process in late 90s/early 00s Instituted AMC system & initiated IPOs of Big 4 in Hong Kong

PBOC intended to proceed with further privatization and financial liberalization MOF acted opportunistically to seize control of most important levers of power beforethe PBOCs reforms could be completed

MOFs political ascendancy strongly reduced the likelihood of further reform

Regulatory reform has been hampered byinternal conflicts between the treasuryMOF and the central bank PBOC

This conflict is reflected in the countrys duelingsovereign wealth funds SWFs:

China Investment Corporation CIC

Central SAFE Investment SAFEThenondescriptentrancetoMOFheadquartersinBeijing


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Perceived success of restructuring via AMCs impeded further reform:

Media outcry after subsequent sales of minority stakes in prized state assets to foreigners

9% of CCB sold to Bank of America, 5% to Temasek Singaporean SWF

Media consensus: if the banks had just been successfully recapitalized, why sell to foreigners?1

Exacerbated already hostile elements in the MOF and other rival state ministries stemmingfrom the PBOCs independent creation of a commercial paper CP market:2

PBOC had previously ceded regulatory power over fixed income to the State Planning Commission

Creating CP market undermined this authority, generated resentment amongst political rivals

Sudden death of PBOC supporter Huang Ju from pancreatic cancer in 2007 shifted balanceof power towards MOF:

Prominent supporter of Jiang Zemin and the Shanghai clique, sworn enemy of Hu Jintao

Politburo Standing Committee member one of the most influential politicians in China

Had favored centralization and supported PBOC in its reform/centralization efforts

Reflects significant influence of individual politicians in determining critical policy outcomes

Party committee granted MOF approval in 2007 to found China Investment Corporation

CIC, a SWF to rival SAFE, the PBOCs existing sovereign wealth fund: MOF had blamed PBOC for rising inflation, accused it of poor management of reserves3

1,2 Walter&Howie,1718

3 Ibid,131


55/91

It is through CIC that the MOF hasenforced its dominance over the PBOCand taken control of the state banks1:

Created by PBOC to top off Big 4 with foreign

exchange reserves in tandem w/AMC bonds 2003 $45 bn to CCB/BOC 2005 $15 bn in ICBC

Filled remainder of gap too large to be pluggedby accounting gimmicks i.e. AMC bonds Former controlling shareholder of Big 4,

majority representation on boards of Big 4/CDBvia Huijin Investment Huijin

Funded by RMB 1.55 trn Special Bond sold by MOF to PBOC in 2007 PBOC then forced these below market coupon bonds on banks MOF used proceeds to buy $200 bn in foreign exchange reserves from PBOC

USD reserves used to capitalize CIC ~1/3 of proceeds used for SWF investment Remainder used to recapitalize ABC/CDB and to purchase Huijin and by extension the Big 4 & CDB from PBOC

1 Walter&Howie,127138


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III. Party & State


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The party not only retains significant influence in allocating capital but continues todominate industry by favoring stateowned enterprise and influencing personnel appointments

Western consensus: Direction of reform since 1978 has remained constant

Gradual reform and liberalization; increasing embrace of private economy and market mechanisms

amidst a dismantling of Stalinist centralplanning apparatus

Reality: Many structural reforms have largely been reversed postTiananmen

Incremental reform has occurred, but efficacy is limited by govt.s distrust of unrestricted market

mechanisms and by the ability of vested interests to circumvent reforms at the local level

Understanding the political dynamic since 1978 is critical to understanding thecurrent and future direction of reform:

We

briefly

review

the

structure

of

the

Chinese

government

before

summarizingthedecadessincereform:

Thelast

thirty

years

have

been

great

on

one

level.

The

economy

has

advanced,

but

culture,

society,andpoliticshavenot. Inessence,itisthesameoldsystem.

Wang Xiaofang, former party bureaucrat1

1 Hongru Liu, TheFormationof theThinkingandReformProposalsforChinasFinancialSystemReforms,2000.


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China has been ruled by the Communist Party of China since 1949: The Party exists above the law and the government:

True locus of political and economic power Authority of the party supersedes all others

Accordingly, prominent politicians typically hold concurrent roles withingovernment and party:

e.g. Hu Jintao is both General Secretary of the Communist Party ofChina and President of the Peoples Republic of China

Party retains power of appointment while party agencies i.e. Central

Organization Dept. et. al. monitor performance of appointed officials

TheHammer&SickleoftheParty

Party led by 25person Nominally appointed by Party Central Committee but selfperpetuating in practice Agenda dictated by General Secretary, decisions achieved by consensus Meets monthly

The Politburo is in turn dominated by the of the Politburo: Consists of 9 most powerful members of Politburo Chinas board of directors

Members represent all major policy areas The contemporary standing committee is increasingly structured to check the excesses ofindividual personalities/offices, i.e. the dictatorial power of the general secretary

Collective wisdom of committee replaces core leaders e.g. Deng Xiaoping, Jiang Zeming Thought to meet on a weekly basis


59/91

Unrestricted by the rule of law, Chinesegovernment is inefficient and inequitable:

Chinas constitution is a mission statementrather than a legal document1:

4 versions since 49, most recent version adopted~30 years ago and modified 4 times subsequently

Unpredictable policy environment with frequentlychanging rules & degrees of enforcement

Without checks and balances & effectiveenforcement mechanisms, policy making &implementation are frequently

Regulatory structures often reflect internecinepolitical conflicts i.e. MOF vs. PBOC

1 Starr,60

2 Starr,64

3 WangJingqiong.BeijingtoCloseThousandsofLiaisonOffices.ChinaDaily,01/25/2011.

Petitionerspleadforrelieffromthecorruptionoflocalofficials

Chinas government is 2

The government relies on negotiated relationships between a large number of individualpoliticians, agencies, and organizations:

Particularly marked in relationship between central and local governments Policy is adhoc and negotiable as central govt. has limited ability to enforce policy at local level Ability of local govts. to negotiate concessions from central govt. reflected in 10,000 liaison offices i.e. localgovernment lobbies in Beijing A Chinese K Street1

Powerful local leaders can run jurisdictions as personal fiefs i.e. Shanghai Clique in 90s, Chongqing in 00s

Abuses can only be stopped by concerted effort from center i.e. corruption scandals/scapegoating ofproblematic officials via Central Committee for Discipline Inspection


60/91

Nominally 3 branches of government:

State Council Source of power and authority

Composed of heads of 26 state commissions and ministries i.e.Ministry of Finance, Ministry of Railways, Ministry of StateSecurity, etc.

State ministries thought to employ 10mm bureaucrats

Complicated management structure local bureaus report to localgovts. as well as to ministry/commission senior office

Further hinders efficient regulation/administration/

enforcement of localities by the center

Supreme Peoples Court No real independent power exists solely to apply party policy

to specific cases/incidents

National Peoples Congress Historically a rubber stamp legislature, conceived of primarily

as an arena where regional delegates could come to learn andunderstand the mass/party line

Delegates now acting with increasing independence i.e. abstainingfrom votes/voting in dissent, but still without any realindependent legislative authority

Theviewfromthetop


61/91

In the absence of a strong federal government, the edicts of the StateCouncil & the larger party superstructure filter through the largelyindependent hierarchy of local governments:

Political capital of local officials determines relative independence fromcenter and other govt. bodies

Officials at one level control the level immediately below them via: Power of appointment

Power to draft budgets and levy taxes

Control over the allocation & redistribution of resources

Since 2008, permitted to run fiscal deficits:

Local officials incentivized to generate short term growth at all costs Debts already est. at RMB 10.7 trn by central govt. in June 20111, 2

23 provincial governments, further divided into:

300 Prefectures including numerous prefecture level city govts.

~2,9000 Counties Avg. pop. of ~500k

~650 Cities further disaggregated into: ~175,000 Townships

950,000 Villages

Countless Districts, Neighborhoods, and Units danwei

ShanghaiMunicipalGovernmentBuilding

PeoplesGrandHallinChongqing,seatofthelocal

municipalgovernment

1 FitchWarnds OverChinaLocalGovernmentDebtBBCNews,09/08/11. Accessed 09/27/11.http://www.bbc.co.uk/news/business148363862 YinNongzhing,DeputyDirectorofFinanceCommittee,NationalPeoplesCongressstatedthatRMB10trn wasaconservativeestimateoflocalgovernmentdebt. QuotedininterviewwithReuters,02/02/11. Accessed8/23/11.

http://www.reuters.com/video/2011/02/02/china facingahiddendebtcrisis?videoId=183875158


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64/91


65/91

Dire need for reform in aftermath of Cultural Revolution Economy in tatters, partys credibility shot after bloodbath led by Red Guards

China came closest to achieving legitimate marketorientedreform in the 80s:

Zhao Ziyang and Hu Yaobang led pragmatic reform movement Disciples of Deng Xiaoping, rose through Communist Youth League

Every single important political reform occurred in the 1980s1

Mandatory retirement of officials, reform of Party Congress, legal reforms, etc.

Efforts to increase administrative autonomy of local governments

Allowed & Permitted limited private banking with state banks benchmarked against

private financials

Party briefly flirted with relinquishing control over capital allocation

Reform and subsequent growth predominantly Areas most affected by Great Leap / Cultural Revolution led reform

Driven by pragmatic local officials who frequently were actingindependently of the center, particularly in the poorest provinces

Cities remained dominated by SOEs and central planners

1Minxin Pei,ChinasTrappedTransition:TheLimitsofDevelopmentalAutocracy, (Boston:HarvardUniversityPress,2006)11.

Zhao(top)&Hu

Architectsofreform


66/91

TVEs led rural growth spurt :

Led by private entrepreneurs, who were given significantfrom localities and Rural Credit/Finance Cooperatives RCCs/RFCs

RCCs ~75% of agricultural loans, ~50% of all loans to TVEs

Despite Western academic consensus Stiglitz et. al., successful TVEs

were owned & controlled: Output, profit, and wages of private TVEs 5070% higher than statemanaged TVEs1

Local govts. subsequently expropriated best private assets in 90s

Economic growth matched by welfare gains for majority of population Rural household income 12.2% real growth from 78882

1 Qisong Lin,PrivateEnterprises:TheirEmergence,RapidGrowth,andProblems,InChinasRuralIndustry,editedbyWilliamA.Byrd.(Oxford:OxfordUniversityPress,1990)181.2 Huang117.

Nian Guangjiu founded

IdiotsSeedssunflower

seedsin1982andisrepresentativeofthe

dynamicentrepreneurial

classthatemergedasthe

statelooseneditsgrip.

Nian was

one

of

the

greatestTVEsuccess

storiesofthereformera,

earninga1mmRMB

profitin1986. Inthe90s

hewasjailedwhilehis

businesswasseizedand

subsequentlyrun

into

the

groundbytheprovincial

government.

A Brilliant Idiot:


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Inflationary surge & subsequent aggressivemonetary tightening , rising youth unemploymentculminated in Tiananmen Jarring for regime but broader unrest was limited due to

material prosperity of rural citizens under 80s reforms

Tiananmen and subsequent leadership changes led tomany reforms being reversed in the 1990s Hu Yaobang forced out in 86 following support of student

protests; his death in 89 was a partial trigger for Tianamen

Zhou Ziyang purged for supporting Tiananmen students

Replaced by Jiang Zeming/Zhu Rhongji The Shanghai Clique

PostTiananmen lesson liberalization must not entailloss of political control

Focus shifted from rural entrepreneurship to statedominated urban economy

Foreign capital systematically favored over indigenousentrepreneurs1

1 Pei(2006)


68/91

In the 90s China embraced state capitalism under Jiang Zeming & Zhu Rhongji Party superficially embraced some market institutions but increasingly encroached on enterprise and finance

through greater centralization and a selective reversal of earlier reforms

Favored urban SOEs and foreign capitalists over indigenous entrepreneurs Rapid development of coastal enclaves like Shanghai, Dongguan, Shenzen, etc. active courtship of FDI

Restricted access to financing for nonstate business, granted generous subsidies to SOEs

Rural and urban income growth stalled as nominal growth took primacy

Administration/fiscal management of rural localities recentralized, lost fiscal autonomy Rural tax burden grew significantly, proceeds used to subsidize urban growth

Rural household income grew just 3.8% from 8901 GDP annualized 16.5% same period1

Govt. bureaucracy ~2x during decade Govt. payroll up from 20mm in the early 90s to 46mm in 20042

Significant recentralization of finance led by Zhu Rhongji to control mid 90s inflation Private financial institutions banned by 1998,3, 4 imposed nonperforming loan reduction quotas on banks

Est. Central Finance Work Commission CFWC to regain authority over bank branches from local officials5

Jiang Zeming subsequently loosened restrictions, resumed decentralization in early 00s Zhu Rhongji supporter Wang Xuebings corruption scandal partially shifted political balance

Welloff society growth initiative designed to cement Jiangs legacy in his final years, required credit growth

1 Huang(2008),117

2 AlbertPark&Minggao Shen.JointLiabilityLendingandtheRiseandFallofChinasTownshipandVillageEnterprises. DepartmentofEconomics,UniversityofMichigan(2001)

3 Shih(2007),177

34 Shukai Zhao,Bianju Zhong DeZiangzhen Jigou [ChangingTownshipOrganizations],StateCouncilInvestigationandResearchReport168(2004)5 Shih(2007),169

Chinese peasants, your name is misery Sun Dawu, rural entrepreneur in Hebei province


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4th generation leaders Hu Jintao & Wen Jiabao

1stgeneration to inherit rule as picked successors

Selected and ushered in by core leader Jiang Zeming

Reflects increasing bureaucratization of party

Hu Jintao President of PRC, Party General Secretary Consensusbuilder, shifted policy priorities from economic growth

towards sustainable development and social welfare scientificdevelopment

Policy strives to create a society centered around a prosperous middleclass harmonious society

Rose through China Communist Youth League CCYL and retainssignificant patronage network of CCYL alumni

Wen Jiabao Premier of PRC, Secretary of State Council

Populist reformer; rose under the patronage of Hu Yaobang, whoappointed Wen to the Central Committee/Politburo

Socially moderate, increasingly outspoken progressive Potentially sympathetic to political reform

Remainder of Standing Committee dominated by formermembers of Jiang Zemins Shanghai clique

6 incumbents inhibit and complicate reform process Difficulties intensified by significant expansion of state bureaucracy

and patronage networks by extension under Jiang Zeming

- Hxi shhu

Harmonioussociety


70/91

Party is increasingly cognizant of potential problems,

but remains wedded to statist solutions 18th 5 Year Plan reflects this approach:

Goal: Rebalance economy on a sustainable footing andreduce rural/urban inequality

Plan: $1.5 trn in infrastructure spending, support thedevelopment of specific higher valueadd industries

Unfunded commitment likely to be financed by state banks

Continuing emphasis on stateled investment andadditional hard infrastructure

Responds to symptoms but ignores structural causes

Critical need for soft infrastructure i.e. establishment ofrule of law, tolerance of private finance, etc.

Pending transition to 5th generation at 18th Party Congressin 2012

Xi Jingping thought to be Hu Jintaos likely successor Moderate centrist, strong reputation on corruption

Rose to prominence largely due to success in various roles inFujian and Zhejiang provinces

Potentially destabilizing political dynamic

No guarantee that current primacy of a balanced StandingCommittee will remain under next generation

Possible that Peoples Liberation Army PLA will seek

representation to reflect its shifting role in the state


71/91


72/91

Chinas privatizations in the 90s proceeded according to the blueprint: Let go of the small, take hold of the big 15th Party Congress, 1997

Dictated by poor performance of state industry

Divested smaller, inefficient SOEs, concentrated on restructured national champions1: Small SOEs ~20% of sector in 97 but comprised majority of operating losses

Small SOEs privatized, laid off 3040mm workers to enhance profitability

Surviving SOEs given tax and debt relief, import licenses, access to domestic and foreign listingfacilities, and reduced operating restrictions

Policy of 2 Guarantees2

Guaranteed access to financing and raw materials for 234 SOEs

Strongly limited need to remain competitive

Restructuring used to and of remaining SOEs Party retains equity ownership, control via corporate boards and personnel appointments

Significant social welfare consequences

1,2 Huang(2008)


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Private sector significantly smaller than headline figures would suggest: Official definitions are problematic:

Nonstate includes many collective enterprises controlled by local governments

Majority of listed SOEs are classified as nonpublic:

However, state retains and control of corporate boards

2005 OECD study suggests private sector is ~70% of economy1

Confusion regarding legalperson shareholding firms ~40% of private sector

OECD views as private, but majority of legalperson firms are owned by state and directly

supervised by state council: OECD list includes subs. of recognized SOEs like PetroChina and China National Petroleum

Corporation as well as state champions like SAIC Motor

75% have zero individual share capital, 45% are merely production subsidiaries of otherSOEs2

Correcting for this, true private sector is 2

Even if we accept the 70% number at face value, share is still low:

Comparable to Indira Ghandis India with nationalized banking system and the license raj

Private sector primarily concentrated in capital extensive service sector

Reflects restricted access to official sources of financing

1 SeanDougherty&RichardHerd,FastFallingBarriers&GrowingConcentration:TheEmergenceofaPrivateEconomyinChina, OECDEconomicsDepartmentWorkingPapers 471(2005)2 Huang(2008)

3 Ibid,p.124


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Majority of listed cos. are stateowned: Only 7% of 19902003 listings from private cos.1

State sector given preferential access to capital markets Most competitive of truly private companies remain private, HKdomiciled

Many of these national champions did not exist before their public listings Western investment bankers facilitated creation of national champions as part of

restructuring/consolidation of SOEs during late 90s2

Exemplifies partys opportunistic use of market institutions to achieve policy goals

China Mobile particularly egregious example3: Created by rolling up assortment of poorly managed provincial telcos. after 1997 IPO

Proceeds from NYSE listing supplemented with bank loans, used to purchase telcos. in6 provinces owned by its own parent

Prospectus referred to a proforma entity not yet operationally integrated Followed by secondary offering in 2000, proceeds similarly used to expand in a

further 7 provinces

Weakest public listings backstopped by strategic investors Statedominated financials, financial subsidiaries of SOEs, and other government

entities AMCs, military industrials, etc. material investors in IPOs

2010 ABC listing 50% of allocations to strategics4

Highlights otherwise lukewarm market reception, partys close involvementin/backstopping of market listings

Party retains majority ownership & control of boards

Party no longer in direct control, but able to exert significant influence indirectly

1 Huang(2008)

2 Walter&Howie

3 ChinaMobileProspectus(SECFormF3),filed10/04/00

4 Walter&Howie,178181.


75/91

1 McGregor(2011),85

Govt. has largely withdrawn from direct

management but asserts equity ownershipindirectly via personnel appointments:

2 primary levers to control appointments:

Central Organization Department COD

Chinas state Human Resources organization Dictates all meaningful leadership appointmentswithin Party and enterprise system Thought to control 70mm jobs Senior bank managers must be approved by COD aswell as PBOC and special banking committee

Committee on Discipline Inspection CDI Used opportunistically by center to controlproblematic local officials Lacks true independence

overseetheappointmentsofUSstategovernorsandtheirdeputies;themayorsofbigcities;headsoffederalregulatoryagencies;

thechiefexecutivesof GeneralElectric, ExxonMobil, Walmart and50-oddoftheremaininglargestcompanies;justicesonthe

SupremeCourt;theeditorsof TheNewYorkTimes, TheWallStreetJournal and TheWashingtonPost,thebossesofthetelevision

networksand

cable

stations,

the

presidents

of Yale and

Harvard and

other

big

universities

and

the

heads

of

think

-tanks

such

as

the BrookingsInstitution andthe HeritageFoundation.1

A hypothetical American equivalent of the COD would:

TheCODsdiscrete,featurelessBeijing

headquarterslacksanysignage


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1 TheodorGroves,Yongmiao Hong,JohnMcMillan,andBarryNaughton, ChinasEvolvingManagerialLaborMarket,JourneyofPoliticalEconomy103(4)87392(1995)

Executives at SOEs are frequently rotated betweenposts at the CODs behest:

Average SOE executive tenure 5.5 years1

Personnel transfers contravene corporate governancerequirements of public listings

Where party and industry intersect, legal obstacles aremere formalities

Selectedpersonnelappointmentssince2000:

China Mobile, China Unicom, & China Telecom CEOs switched places without warning to break upemerging centers of power

Heads of 3 airlines rotated to reduce price competition

Vicegov. of PBOC made CEO of China Construction

Bank As if Janet Yellen was given Jamie Dimons job

CNOOCs chairman appointed governor of HainanChairman of Huaneng Power made dep. gov. of Shanxi

Chairman of Chinalco elected to cabinet advisory post


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54 of 100 SOEs on central nomenklaturalist1

Chairman/CEOs hold ministerial rank and selected by COD Less powerful StateOwned Asset Supervision & Administration

Commission SASAC selects CFOs/VPs Especially influential in Big 4 banks

Party Committees formed within large companies to insurepolitical correctness/policy implementation Committees active even in foreign businesses / JVs Sleeper cells introduced postTiananmen to be activated during crises

Politicization of management creates problematic

conflicts: Can a bank manager refuse a loan to an executive with greater

standing in the party?

SOEs used to propup failing cos. via strategic investment2

China Mobile Purchased 20% of Shanghai Pudong Devleopment Bank for $5.8bn China Unicom Rumored to have invested in BoCom via opaque subsidiary

Mirrors SOE backstopping of otherwise thinly subscribed equity offerings

The Red Machine Top executives at largest SOEs reportedly receive an encrypted 4digit

telephone line the socalled Red Machine3

Communications link between party elite Symbolic of symbiotic state/big business relationship

1 Walter&Howie,169

2 Walter&Howie,192

3 McGregor(2010),78

Theultimatestatussymbol?

Zhongnanhai,theChineseKremlin


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Source:WorldBank,Bloomberg

ReflectsROEof Nikkei225,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%

3YearAverageGDPGrow

th

3 Year Avg. Return on Equity

Despite significantly higher GDP growth Chinese firms lag emerging market peers

as well as some developed markets in return on equity


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1 Madar,Daniel,BigSteel:Technology,TradeandSurvivalinaGlobalMarket,(Vancouver:UBCPress,2009)116. Assumesminimumefficientscaleat5mmt(conservative)2 WorldSteelAssociation

Chinas steel industry is indicative of the dangers ofthe state controlling enterprise:

Industry demands scale but fragmentation increasing: Top 5 producers 1/3rd in 88, only 1/5th in 08 Contrasts with global consolidation trend Fragmentation driven by meddling of local officials

Highly fragmented and inefficient

Economies of scale limited due to state price controls Estimated that only of Chinese steel mills

1

Surplus capacity and continuing irrational growth Capacity EU Japan Russia US combined2

Significant idle capacityOnly 5% of steel exported

Predominantly lowgrade long products Limited valueadd, must import higher grade flatproducts


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Inefficient industry aided and abetted bypervasive accounting fraud: 99% of SOEs have falsified accounts to some

extent1

Sloppy due diligence, weak disclosure,

limited scrutiny by underwriters Regulatory report issued in late March

criticized 17 banks for listing practices

Recent frauds unnoticed by highprofileauditors and investors in the west LongTop, China Media Express, SinoForest, etc.

Reflective of undue Western optimism?

in frauds Cash holdings significantly overstated by

corporates brazen, easily falsifiablemisrepresentations

17 SOEs have admitted to misreportingfinancial data in 20112

Hong Kong Stock Exchange acceptsChinese auditors as of late 2009

Chinesefraudshavepassedmusterwithsomeofthe

Westsmostrespectedauditorsandexchanges

1 Shih(2007),175,GordonChang,TheComingCollapseofChina (NewYork:RandomHouse,2001)2 JamesGrant,GrantsInterestRateObserver,6/3/2011,NationalAuditOffice.


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1 NewYorkTimesDealbookChineseReverseMergerCompaniesDrawLawsuits,7/26/11. Accessed8/23/11,http://dealbook.nytimes.com/2011/07/26/chinese reversemergercompaniesdrawlawsuits/

0.00

0.50

1.00

1.50

2.00

2.50

3.00

Chinese Rev.Merger Index

Russell 2000

TheInfamousChineseReverseMerger

Pervasive accounting fraud in USlisted Chinese stocks Exchanges have halted trading pending outcome of SEC investigations Accounted for almost 50% of federal securities classaction lawsuits in 2011 YTD1


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Lax accounting standards facilitate a large market for off

balance sheet finance:

Entrusted Loans Corporate/household depositors contribute funds to trusts managed by bank

Proceeds loaned to 3rd party borrowers

Circumvents interest rate caps and lending quotas imposed on banks

Bank earnings increasingly driven by off balance sheetvehicles Entrusted OBS loans est. at ~8% of all lending in 2010 1

OBS loans up in 20112

Reportedly 40% of entrusted loans go to property developers3

Figures represent only officially recognized OBS vehicles

Bogus Trade Finance Phony invoices reportedly used to import physical commodity

assets that can be levered Favored by property developers maxed out in aboveground

domestic/offshore markets Also used to circumvent capital controls

Copper favored previously, Soy increasingly popular

Enormous contingent liabilities Undrawn credit commitments at Big 4 RMB 7.4 trn 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/2011 0623/offbalancesheetloansdoubleboostingbankdefaultriskchinacredit.html4 JamesGrant,GrantsInterestRateObserver5/20/11.


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V. Structural Vulnerabilities


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Corporate creativity in accountingis mirrored in official governmentaccounts:

Govt. economic figures are forreference only Li Keqiang ), heir apparent to

Wen Jiabao, Chinas reigning technocrat

Official govt. debt RMB 6.5 trn AMC program and other measures reflect explicit intention to minimize stated debts1

Government has significantOBSdebts(2010E): Unfunded MOF receivables and sterilization bills RMB 2.6 trn

AMC debts, 20032005 RMB 2.7 trnNonconsolidated debt of State Ministries RMB ~400bnNonconsolidated local govts. (largely 0809 vintage) RMB ~10 trn Policy bank debt RMB 4.5 trn

Govt. retains ultimate responsibility for state financial system Govt. OBS debt likely 34x officially disclosed debts total debt: ~100+% of GDP2

1 Shih(2007)171

2 VictorShih,LoomingProblemofLocalDebtinChina.AsianWallStreetJournal,2/10/10.


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Consensus view: Govt. can recap. financial systemwith enormous foreign exchange reserves

Reality: Debts vastly understated, ability to deployforex reserves domestically is limited

Investing forex reserves domestically would unwindliquidity overhang on PBOC balance sheet

Portion of reserves already invested domestically,including holdings of bank equity

Suggests only a fraction of reserves could be

quickly deployed to recapitalize the bankingsystem / arrest an evolving systemic crisis

Chinas fiscal position is a complex web of offbalance sheet entities and unfunded commitments

Headline debt/GDP grossly understates liabilities State enterprise system de facto liability of the state

Ultimate liabilities of Chinese stateare


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Enormous inequality concentrates wealth

1% of Chinese households 0.4% of populationcontrol upwards of $35 trillion depending onassumptions1

Reallocating 3040% of this wealth overseas woulddrain majority of domestic reserves2

Negative deposit rates and limited channels fordomestic investment promote capital flight

Weakening returns on domestic equities, real estateshould accelerate capital flight

Capital controls are porous, particularly for wealthyand politically connected

Underground banks / moneychangers

Bogus trade invoicing

Increasing currency liberalization

Evidence suggests capital flight is already underway

Increasing investment by Chinese nationals overseas

Real estate in US, Canada, Singapore, Australia, etc.

1,2 VictorShihHighWealthConcentration,PorousExchange Control,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

Chinesebuyers

accounted

for

almost

11%

of

US

real

estatetransactionsin20113


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VI. Conclusion


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While progress has been made, China effectivelyremains a command and control economy at heart:

No more central planners, but party distorts mostcritical market prices/mechanisms

A China bull must believe in stateled capitalallocation and that it can be successful on a scaleunprecedented in human history

How is this different from the old days?

China is more radical The State wants to lead everything.This is the greatest difference

Yuan Weishi, Zhongshan University1

1 McGregor(2010)78.

2 CIA

Precedent: The Soviet Union managed thesame feat in the 50s ~7% compound

growth by boosting investment spending2

As If All This Wasnt Enough


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As If All This Wasn t Enough

Chinas demographic dividend is fading: Population of working age projected to shrink at 0.1% p/a from 20152025 1

Significant reversal of previously benign demographic trends

One child policy has created gender imbalance

117:100 male/female ratio in 2010 40 mm more men than women by 20202

Increasing social unrest 80,000 mass incidents in 07, up from 60,000 in 06

No recent official data but leaked data suggests as many as 125,000 incidents in 083

Recent surge of incidences including suicide bombings

Has led to increasingly violent crackdowns

Harassment of foreign journalists, arrests of intellectuals and activists,resurgence of Maoism 4

State has increased allocation to state security 14% in latest budget5

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

How Now Brown (Red) Cow?


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How Now Brown (Red) Cow?

China has before it two alternate paths:1. Status quo

Unsustainable, unfair, unbalanced, and inflationary

System incapable of surviving slow global growth environment Inflation will continue to mount, inflame social tensions, and undermine party credibility Sheer scale creates upper bound to capital/resource intensive growth model Debt financed growth + poor capital allocation + low recovery rates + understatedinflation recent economic growth is likely overstated & perhaps altogether illusory

2. Structural reform

Reforms required are inherently longterm unlikely to ease immediate pressures Would require party to drastically reshape relationship to state and enterprise

Significant relinquishment of power & effective admission of failure by CCPSignificant impediments:

Dependency on domestic savings for financing Fundamentally uncompetitive industry Entrenched political/bureaucratic incumbents inhibit rapid/effective reform Unresolved liquidity overhang on PBOC balance sheet

Significant human capital deficit from chronic social underinvestment Mounting pile of unresolved bad debts stretching ~20 years

Acknowledgements


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Acknowledgements

I would like to dedicate this presentation to thecourageous efforts of Chinas private sector business menand women, who have frequently persevered despite the bestefforts of the corrupt, arrogant, and repressive regime of theCommunist Party.

This document owes a significant intellectual debt to thework of many but I would like to especially recognize thecontribution of the following scholars:

Carson BlockJames Grant Fraser Howie Yasheng Huang Victor Shih Carl Walter

Dali Yang

communism comes of age

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