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

"The New China of the 21st century is a creation of the Goldman Sachs and Linklaters & Paines of the world just as surely as the Cultural Revolution flowed from Chairman Mao's Little Red Book....if there is a single reason why the world is in awe of China's economic miracle today, it is because international bankers have worked so well to build its image so that minority stakes in its companies could be sold at high prices, with the Party and its friends and families profiting handsomely."

"The key point that stands out in the (China Mobile) transaction is that a subsidiary raised capital to acquire from its parent certain assets by leveraging the FUTURE VALUE of those same assets as if the entire entity - subsidiary plus parent assets - existed and operated as a real company. The value of the provincial assets, as far as the IPO goes, was based on projected estimates of their future profitability as part of a NOTIONAL company that was compared to the financial performance of EXISTING national telecomm companies operating elsewhere in the world."

"The valuation of such assets was purely a matter of China's negotiating skills, flexible valuation methodologies employed by the investment banks, and demand in the international capital markets."

Chinese banks, despite their Fortune 500 rankings, are not even close to being internationally competitive. They simply do not operate like banks as understood in the developed world. Their years of protective isolation within the ‘system’ have produced institutions wholly reliant on government-orchestrated instruction and support… Their market capitalisations are the result of clever manipulation of valuation methodologies… China’s banks are at the mercy of domestic political disputes and this emphasises their passive role in the economy. [...]

In short, China’s banks face severe challenges on three fronts. In addition to their structural exposure to NPL [non-performing loan = bad debt] portfolios of the 1990s, there will inevitably be new NPLs arising out of their lending spree of 2009. Thirdly, the banks are fully exposed to both interest rate-related and credit-induced write-downs in the value of their fixed-income securities portfolios.

When transferring to these central SOEs [state owned enterprises, which include all the largest companies in China] the former ministry officials were able to retain their positions on the Party list controlled by the central Organisation Department… The chairmen/CEOs of these companies hold ministerial rank…

Chinese investors refer to their stock markets as ‘policy markets’ for this very reason: they move on the expectation of government policy changes and not on news of company performance. The fundamental value-generation proposition in China is the government, not its enterprises.[...]

Since China’s stock markets, which include Hong Kong, are not places that decide corporate control, the pricing of shares carries little weight when thinking about the whole company simply because it is never for sale… This leaves share price to simply reflect market liquidity and demand at any given time.

When PetroChina acquires companies overseas on behalf of the government, isn’t it also a sovereign wealth fund? All this demands the simple question: What in China isn’t a sovereign wealth fund?

The collapse of Lehman Brothers in September 2008 [...] changed this equation completely. The Chinese government acted as if a veil had been removed from its eyes… This American model [...] suddenly lost all credibility. But there was nothing to take its place. The banks, suddenly without restrictions, not only went on their famous lending binge, but also sought to grab as many new financial licenses as possible.

As it looks like the West, international investors easily accept what they see: they are excited by it because it is at once so familiar and so unexpected. There is the feeling that all can be understood, measured, and valued. They would not feel this way if China explicitly relied on a Soviet-inspired financial system even though, in truth, this is largely what China retains.

The question is often raised: does it matter how the Party manages this machinery for failed financial transactions? China, after all, has the wealth to absorb losses of this scale, if it is determined to do so. The answer to this question must be “Yes.” Every day, the press carries stories about China’s National Champions and its new sovereign-wealth fund seeking out investment opportunities in international markets. The internationalization of the renminbi has made headlines as China seeks to challenge the dominance of the dollar as the international currency for trade and, perhaps someday, the international reserve currency. But little is heard from China’s banks; why?

When in 2008 the Western banking sector was in full disarray and the world was applauding the Chinese for their stimulus package, Merrill Lynch and Morgan Stanley were going for a song. Where were China’s banks? A small deal in South Africa and a community bank in California were all there was to show for these proud financial giants. More recently, the head of one of the Big 4 banks dismissed the growth opportunities of developed markets such as the US: tell that to Jamie Dimon! One can well imagine how the US Government would have been forced to react had ICBC come to the Department of Treasury in those dark days with a full cash offer for Citigroup, Wachovia, Washington Mutual or Merrill Lynch. For China, the whole shopping basket would have been cheap. Opportunities forgone in a period such as the world has just passed through may never present themselves again. In contrast, China’s corporates, the China Development Bank, and its sovereign-wealth fund have actively sought international investments: why haven’t the banks?

Put another way: if market valuations for Chinese banks are real and the banks are in such great shape, why hasn’t China’s banking model been exported? As US and European regulators and governments look for a way to prevent the next financial crisis, why is China’s model—with its asset-management companies, outright state ownership and central bank lending—not invoked? If, as some predict, China seeks to replace the US at the center of the global economy at some time in the near future, one would expect it to export not just capital, but also intellectual property. It is nowhere to be seen, nor is it expected.

The story of the past 10 years suggests that China’s banks, despite their Fortune 500 rankings, are not even close to becoming internationally competitive. They simply do not operate like banks as understood in the developed world. Their years of protective isolation within the “system” have produced institutions wholly reliant on government-orchestrated instruction and support. When the Organization Department determines a bank CEO’s future, what can be expected? Despite the prolonged effort to reform the corporate-governance mechanism of the banks, can anyone believe that a bank’s board of directors is more representative of its controlling shareholder than its Party Committee? These banks are undeniably big, as they always were, but they are neither creative nor innovative. Their market capitalizations are the result of clever manipulation of valuation methodologies, not representative of their potential for value creation. In 2010, as one Chinese bank after another announced multi-billion-dollar capital-raising plans, one wonders what happened to the huge amounts of capital each had raised just three or four short years ago. Despite apparently outstanding profits, they have not grown their capital fast enough and that is even without considering any mark-to-market valuation of the now perpetual AMC bonds or their huge exposures to the domestic bond markets. The fact is they are now, and were even after their IPOs, undercapitalized for the risks they carry on their balance sheets, and this accounts for their outstanding return-on-equity ratios.

China’s banks are at the mercy of domestic political disputes and this emphasizes their passive role in the economy. As others have noted, China’s banks have traditionally operated like public utilities. Zhu Rongji’s effort to push the banks toward an international model has been stopped and the banks have reverted to their traditional role. Without question, in 2010, they are again huge deposit-taking institutions, extending loans as directed by their Party leaders. Whatever degree of influence their boards of directors and senior management may have gained over the past decade, from 2009, they are no longer much more than window-dressing, as is the previously well-regarded bank regulator. If banks are about measuring and valuing risk, these entities, having begun to learn, have now quickly forgotten.

Any argument that they have no need to study “that American stuff” since the bulk of their “lending” is to state enterprises is demonstrably specious: SOEs don’t repay their loans. Banks know that it does not matter whether or not such loans are repaid. First, the Party has taken all responsibility and management cannot be blamed for following orders. Second, as this chapter has shown, there is already a well-proven infrastructure in place to hide bad loans. The future development of the AMCs, as well as the almost-virtual “co-managed account,” now seems assured. Careers can be lost only if managers fail to heed the Party’s rallying cry. It is the Party, and not the market, that runs China and its capital-allocation process.

In the absence of public scrutiny, few have called into question the quality of bank balance sheets and earnings. This is understandable domestically, where the media is subject to the Party’s “guidance,” but it is also the case outside of China. International stock markets and brigades of young equity analysts have lent the credibility of their institutions to the idea that banks in China are just that, banks, and have value, if not as individual institutions, then as proxies of the country’s economy. That is just the point: they are indeed proxies of the economy “inside the system.” In this economy, the Party makes what organizational arrangements it likes, a prime example being the bank buy-back of the un-restructured AMCs. The public line supporting this idea as put forth by an analyst at a major American bank goes: “The asset managers will have the largest capitalized banks in the world behind them which are interested in their expanded business, so there are valid business reasons why this [investment in the AMCs] should happen.” Other foreign analysts at major institutions have eagerly echoed this thought.

Such unthinking commentary does China no service. It would be even more dangerous if the Chinese government were lulled into believing that the Big 4 banks are in fact world class and proceeded to encourage them to expand internationally. What effect would the consequent scrutiny by Western regulators and media have? Having seen what constant media focus on sub-prime debt and securitization vehicles caused in the US in 2008, however, no one should be sanguine. Bear Stearns and Lehman Brothers, it should be remembered, disappeared over a weekend. China’s political elite has surely learned a lesson from this experience, just as it has from other international financial crises.

In China, political imperatives make significant internationalization of the banks unlikely. The Big 4 banks form the very core of the Party’s political power; they work in a closed system with risk and valuation managed by political fiat. True, China’s banks have taken on an international guise by public listings, advertising campaigns and consumer lending. As 2009 has shown, however, such change is superficial: true reform of their business model remains a goal that will be the more difficult to reach the closer it is made to seem. These banks will always be closely guarded and directly controlled domestic institutions. Leaders of major international banks in recent years have spoken of creating “fortress balance sheets” able to withstand significant economic stress. In China, there is also the drive to create a fortress, but it is one that seeks to insulate the banks from all external and internal sources of change in the belief that risk should remain under the Party’s control.

In 2009, China’s banks extended a tidal wave of loans exceeding RMB10 trillion. If in the next few years, these loans do not give rise to a significant volume of NPLs and continue to be carried on balance sheets at full face value, the banking system by definition must continue to be closed. On the other hand, if risk classifications based on international standards are applied consistently, a repeat of the 1990s experience is in the making, with huge volumes of unpaid loans and the banks again in need of a massive recapitalization. Already, the tsunami of lending and high dividend payouts have stretched bank capital-adequacy ratios and forced the need for more capital, which comes largely from the state itself. It is somewhat ironic that the demand for capital can also be mitigated by reducing loan assets, ensuring that the AMCs will continue to play a central role.

There is a further important aspect to this arrangement. Over the past several years, China’s banks have enthusiastically entered consumer businesses; credit and debit cards, auto loans and mortgages have become common in the country’s rich coastal areas. From 2008, the collapse in exports has revealed a great weakness in China’s export-dependent economic model; experts from all sides have urged the government to develop a domestic consumption model similar to that of the US (always the US model!). Pushing in the same direction is China’s ageing demographic. If the government does seek to replace export demand with domestic consumption, this suggests that the domestic savings rate will decline, as will household deposits. What will happen to the banks then? Today’s financial system is almost wholly reliant on the heroic savings rates of the Chinese people; they are the only source of non-state money in the game. The AMC/PBOC arrangement works for now because everyone saves and liquidity is rampant. What happens to bank funding if the Chinese people learn to borrow and spend with the same enthusiasm as their American friends? From this viewpoint, a profusion of new investment and consumer-lending products appears unlikely. Similarly, this view suggests that full funding for social security is a reform whose time will not come.

Finally, there is the foreign banking presence. International banks were very active in the negotiations leading to China’s accession to the World Trade Organization, producing a detailed schedule that opened China’s domestic banking markets. China has largely abided by the agreement and, over the past eight years, foreign banks have invested heavily in developing networks and new banking products. With a focus primarily on domestic consumers, new branch networks and the brand advertising of the major American and European banks have become common in China’s major cities and media. Foreign banks have also been quick to engage in the development of a market for local-currency risk-management products.

These banks understand that China and its financial system are in transition and most are prepared to persist in the expectation that at some time in the not-too-distant future, the market will be open fully to them. This was the commonly held position prior to 2008. But the conclusions about the global financial crisis now being drawn by the Chinese government suggest that opening and reform along the lines of the now apparently discredited international financial model will no longer continue. This is not to say there is another model . . . except for the prolongation of the status quo, and this is the direction to which recent events point. What future, then, is there for foreign banks in China?

In summary, China’s banks operate within a comfortable cocoon woven by the Party and produce vast, artificially induced, profits that redound handsomely to the same Party. As demonstrated by the 2008 Olympics or the wild celebrations of the country’s sixtieth anniversary, the Party excels in managing the symbolism of economic reform and modernization. Ironically, however, if the Asian Financial Crisis in 1997 caused one set of Chinese leaders to see the need for true transformational reform of the financial system, the global crisis of 2008 has had the opposite effect on the current generation of leadership. Their call for a massive stimulus package reliant on bank loans may have washed away for good the fruits of the previous 10 years of reform. Even more ironic, while the “good” banks have been weakened, the “bad” banks created for the earlier reform effort are being strengthened, perhaps in preparation for the next inevitable wave of “reform.” If emerging markets are so defined because their institutions are always “in play,” buffeted by the prevailing political needs of the government, then real change depends on the next major crisis and a Party leadership willing to accept that today’s symbols do not reflect underlying reality and that the true needs of China’s economy are not being met.

China’s debt markets are captive both to a controlled interest-rate framework on the one hand, and, on the other, to investors that, in the end, are predominantly banks. To understand why China’s bond markets are moribund requires digging into the technical details. But seeing how these markets are controlled is a key part of understanding how the Party manages China’s financial system: the symbols of a modern market are there, but the market itself is not.

Over the past 18 years, China has developed stock and debt-capital markets, a mutual-funds industry, pension funds, sovereign-wealth funds, currency markets, foreign participation, an internationalist central bank, home loans and credit cards, a burgeoning car industry and a handful of brilliant cities. As it looks like the West, international investors easily accept what they see; they are excited by it because it is at once so familiar and so unexpected. There is the feeling that all can be understood, measured and valued. They would not feel this way if China explicitly relied on a Soviet-inspired financial system even though, in truth, this is largely what China remains.