Tiger Woman on Wall Stree (28 page)

There is even less chance that China will allow a state-controlled bank to fail. Chinese banks are huge. At the end of 2012, ICBC overtook Bank of America to become the world’s largest bank in terms of Tier-1 capital, a measure of a bank’s financial strength. As of 2013, China was home to 4 of the world’s 10 largest banks for Tier-1 capital, the
same number as America
. This means that, regardless of the ownership structure of these banks, they are too big, as well as too politically connected, to fail. Just as was the case during previous bank recapitalizations, the Chinese government is not likely to let the depositors of the banks get haircuts if the banks become insolvent. Instead, it would likely write down some of the banks’ nongovernment-owned equity.

Those in the bank lending chain, from creditors to depositors, know this, and therefore believe the Ministry of Finance implicitly guarantees their debts. That is why Chinese banks weren’t that worried about piling up nonperforming loans with the lending spree in 2009 and 2010.

In return for that implicit guarantee, Chinese banks willingly carry out the government’s bidding. When it comes to loan approvals, fulfilling political obligations is far more important for Chinese banks than a project’s financial viability is. This is yet another fact that most investors coming from market-based economies find hard to comprehend.

Since the beginning of China’s economic reforms under Deng Xiaoping in 1979, local governments have had to pay a
dramatically rising share of total public expenditures, while the central government’s share has fallen. At the same time, the local governments’ share of taxes and fees has declined steadily. But as China’s economy expanded at an unprecedented pace over the last decade, local governments found a way to close this growing gap by selling land.

Land prices rose quickly as China developed, giving the local authorities abundant collateral and resources with which to pay off debt or meet their obligations to the often loss-making SPVs they created to borrow on their behalf.

In China, the government technically owns all the land; however, land titles can be leased to private groups for periods of 40 to 70 years, depending on how the land is zoned. Local governments are responsible for auctioning off these parcels and make huge sums of money in the process. They often obtain these land titles, though, through a combination of inadequate compensation and intimidation or coercion, giving rise to social tensions among the very people whom developing is aimed
at benefiting
. But with few other revenue sources and such large sums of money available from reclaiming land at low prices and selling it to developers, most local governments find land sales hard to resist.

This financing model proved highly risky when there was an economic contraction. Local governments, rather than the central government, account for most of China’s infrastructure expenditures. But when the Chinese economy began to decelerate as stimulus spending wore off, real estate and land markets cooled and local government revenues from taxation and land sales collapsed. At the same time, local governments faced increasing pressure to stimulate the economy by boosting investment. As local governments took out more loans through SPVs, their borrowing caught up with and then eventually exceeded their capacity to service, let alone repay, their debt.

As the global economy remained sluggish, the legacy problems from China’s overinvestment in 2009 began to rear their heads, including the often-talked-about imbalance between domestic consumption and investment. Much of China’s economic growth had been sustained by fixed-asset investments led by the government, resulting in an increasing role of the government at the expense of consumers and the private sector.

In China, domestic consumption lingered around 35 to 40 percent of GDP—dozens of percentage points lower than that of any other major economy, including the United States at 70 percent and
Japan at 60 percent
.

Some economists claim that capital expenditure figures for China overstate the real amount of investment in the economy, because China’s investment figures likely include a high percentage of unrecorded “corruption rent”—income and wealth extracted from corrupt practices—which eventually is used to buy high-end luxury products or spent in Macao casinos. However, there can be little doubt that the Chinese system excels at pumping money into investment projects and that industries such as steel mills, chemicals, and high-speed railroads are experiencing selective but growing overcapacity.

Economists widely recognize the danger of the structural imbalance between investment and domestic consumption in China. However, the inequity between the large SOEs and the small and medium-sized enterprises (SMEs)—the SMEs being the bedrock of China’s real economy and engine of organic growth, innovation, and employment—represents a worse problem whose significance is often underappreciated.

In terms of long-run growth, the way credit is allocated in the economy is just as important as the total amount of credit. China’s economic growth has been predominantly driven by low-margin and high-volume production, a system that favors SOEs in the manufacturing and industrial sectors that can obtain economies of scale. The service sector and private businesses in general have been starved of credit—one of the reasons that many private Chinese companies come to U.S. capital markets to raise funds. A further obstacle to start-ups and their subsequent growth is the fact that individuals and SMEs cannot collateralize land effectively, since the government technically owns all land in China.

As economies grow richer, structurally more complex, and more diversified, central planning and personal connections become less effective means of allocating resources, from natural and human resources to credit. The rule of law, markets, and arm’s-length regulation are far more effective and efficient in this regard. It is clear that China has reached a point in its development where it should move toward a rules-bound market economy and away from the top-down micromanagement that served the country well for the previous 30-plus years.

Proponents of state capitalism argue that SOEs played a strategic role in driving the economy during its early catch-up growth phase, in which China’s central planners took advantage of a surfeit of cheap labor and heavy capital investment to create the world’s biggest manufacturing-driven export-oriented success story. This model eventually hit the wall, however, as overall inflation (including wage, rents, material and other resources) squeezed the profit margin—in many cases to negative earnings—for many industrial sectors.

As this model became obsolete, SMEs began to prove vital in transforming China into an innovative economy driven by domestic consumption and capable of making optimal use of scarce and skilled labor. SMEs—mostly small businesses that have sprung up
since the start of market-oriented reforms in the 1980s—contribute more than 65 percent of China’s GDP and are responsible for 75 percent
of employment
.

Innovations are rare among SOEs simply because innovation requires risk taking and a corporate culture that rewards it, something that is not encouraged in the central planning culture of SOEs. Executives who come to their bosses with innovative ideas can expect a small upside in the case of success, maybe a marginal pay raise, but a much larger downside in the case of failure—perhaps losing their job. Taking orders, not risks, is the unwritten rule of thumb for SOE employees.

Despite all the benefits they delivered to the Chinese economy, SMEs have not been given the government support they deserve. For one, SMEs are significantly handicapped in competing for cheap capital. This is partly because the government favors SOEs, but it is also because bank lending in China is collateral based. SOEs tend to operate in established and asset-heavy industries such as telecom, infrastructure construction, and steel, giving them plenty of fixed assets to put down as collateral. Because of their ties to local governments, SOEs also have much better access to land titles (rights to use the land), the collateral of choice for as long as banks have existed. Meanwhile, a high percentage of SMEs compete in service industries, with little or no fixed assets. SMEs also often have a short track record of operation and little or no credit history, a universal source of funding problems.

SOEs are far more likely to be able to obtain adequate capital on affordable terms, permitting them to expand their businesses. SMEs, cut off from bank loans, have to turn to the gray market to find capital. In Wenzhou, the capital of Chinese capitalism, SMEs borrow at interest rates as high as 85 percent, while SOEs often take out loans at single-digit interest rates. As the flood of bankruptcies in eastern China in 2011 demonstrated, borrowing at such high interest rates is an extremely risky practice for small businesses.

Until the summer of 2011, China’s economic juggernaut seemed unstoppable. But starting in the fall, an acute credit crunch hit Wenzhou. A coastal city of 9 million about 300 miles south of Shanghai, Wenzhou had been a prosperous treaty port for centuries. It had earned a reputation as a hub of private wealth and enterprise, with a business-minded population known for its self-reliant and independent streak.

The city specialized in low value-added manufacturing, producing 70 percent of the world’s cigarette lighters and 60 percent of its buttons, among other products. But since 99 percent of Wenzhou businesses were private, entrepreneurs didn’t have access to affordable bank loans to fund their businesses. Therefore they had to borrow from underground banks and pawnshops, and the city soon became a nexus of shadow banking—and eventually an illustration for its risks.

Shadow banking typically refers to a system of credit intermediation between savers and borrowers involving entities and activities outside banks. In the United States, the main shadow banking players are hedge funds, venture capital, and private equity funds. Payday loan providers and money market funds are also considered part of the shadow banking system. Like banks, they borrow short and lend long, or else they fund themselves using short-term, liquid instruments while investing in long-term, often illiquid assets. Both banks and shadow banks experience mismatches in terms of liquidity, credit risk, and the duration or maturity of their assets and liabilities. Unlike banks, however, shadow banks often escape the close scrutiny of regulators and supervisors, even though many of them are owned or controlled by banks or bank holding companies.

In China, the world of shadow banking includes many smaller and less-regulated entities, including trust companies, pawnshops, guarantors, small lenders, underground banks, and wealth
management products marketed at banks. Since these activities take place outside China’s regulatory framework, figures on the scope of shadow banking are imprecise. But some economists estimate that total public and private debt, including shadow bank loans, could be as high as
200 percent of GDP
.

In Wenzhou, private business owners took out loans from shadow banks to invest in their projects, sometimes expanding into unrelated and highly speculative projects such as real estate development. A credit bubble slowly grew in the city. With little or no regulation of underground lending and other forms of shadow banking and no required disclosures, shadow bankers were less able to assess risk and ultimately lent to riskier businesses. The shadow banking system was vulnerable to several potential stress points, including the deterioration of the real estate market, the weakening of exports or manufacturing returns, or even the investments of individual entrepreneurs going bad.

It wasn’t just one of these factors that was Wenzhou’s undoing—it was all three together. These financial arrangements worked fine when there was optimism, confidence, and trust between parties. But those sentiments didn’t survive the financial crisis. As the global recession deepened and demand for exports plunged, the whole town began to default. Optimism, confidence, and trust turned into pessimism, fear, and distrust, and the complicated layering of credit and debt created during Wenzhou’s good times imploded much faster than it had grown. Loan sharks disappeared in the middle of the night, construction ground to a halt on half-completed apartment blocks, and property prices plunged. More than 80 prominent local businesspeople committed suicide or declared bankruptcy as they found themselves unable to pay back their
gray market loans
. China’s high-speed economy appeared to be running off the tracks, with Wenzhou leading the way.

The situation continued to worsen in 2012. In a note uncharacteristic of the typically bullish nature of most sell-side analyst
reports, one bank analyst issued a report that summer describing in detail the desolate streets and empty department stores of a now-bankrupt Wenzhou. The analyst noted that factories had shuttered their doors for a month or more after seeing orders decline by one-third, year on year, and that owners said this was the hardest time they’d seen in 18 years. Prices at a luxury riverside residence dropped to 50,000 RMB per square meter from more than 70,000 RMB in one year. “Fiddling with iPhones, reading newspapers, playing cards and sewing have become the favorite pastimes. . . . It isn’t what I expected at all,” the analyst wrote. “I was hoping to be overwhelmed by skyscrapers like Shanghai’s or roads like Beijing’s. But Wenzhou is disorganized. Debris and waste dot the city.”

This account showed the deplorable consequences of the triumph of China’s unique form of state capitalism, characterized by the distorted allocation of capital and human resources and the consequent uneven playing field. SOEs were still surviving and even thriving because of their monopolistic positions and government support. But private enterprise, the source of most of China’s GDP and jobs, was struggling, with slim access to financial and human capital.

One facet of shadow banking—wealth management products, or WMPs—has deeply penetrated the ranks of retail investors around the country. Many Chinese, including friends and families I know in China, purchased these financial products at one time or another, since they offer a significantly higher yield than saving accounts do.