Thursday, May 07, 2009

Strategies for Late-late-late Capitalist Development Part Two

Read Part One here.

3. Reforms: From decentralisation to re-centralisation

Maoist China had only the People’s Bank of China (PBOC) as the sole financial institution. Under the centrally-planned economy it served a redistributive function and allocated funds to state-owned enterprises.

Bank diversification, as part of the over-all reform process, was initiated by the Deng regime. The PBOC began to assume a pseudo-central bank function. It remained the main financial institution controlling 80 percent of deposits and issuing 90 percent of all loans by financial institutions. A second bank was created, the Bank of China. As a PBOC’s subsidiary, it was charged with foreign exchange transactions, working closely with state-owned companies. Third was the China Construction Bank (CCB) which disbursed funds which came from the state budget for the state economic plan. Lastly the Industrial and Commercial Bank of China (ICBC) was created in 1984 to take over the commercial banking functions of the PBOC. These major banks would then be called the ‘Big Four.’

Like most developing countries, the Chinese government is a major employer. Until 1994, the central government supported SOEs not only to foster industries but also to maintain full employment. As of 1995, 83 percent of all SOE loans were from the Big Four. Estimates of as much as 40% of these loans are based on “policy directives” rather than commercial profitability.

The economic reforms of the late 1970s made China’s non-state sector the economy’s growth engine. This sector, which included township and village enterprises (TVEs) in the cities, collectively-owned enterprises in the countryside, private enterprises and foreign-invested enterprises (FIEs), benefited greatly from market liberalisation which removed trade barriers in various goods and facilitated import of raw materials. This growth was however constrained by the nature of the China’s financial system, which was primarily geared towards financing state-owned enterprises.

Post-1994 reforms

It is estimated that China has lost $500 billion on non-performing loans (NPLs) to SOEs, a rough equivalent of all total FDI China has garnered since 1979. These loans are characterised as ‘value-destroying’ as there is “little or no hope of repayment (Calomiris 2007: 4).”

To alleviate losses in policy-directed loans, so-called because of their political impetus, further banking diversification, along with other policies, were carried out in since 1994. Three financial institutions were created to address specific development policy objectives – the Agricultural Development, China Development and the Export-Import Banks. This freed up other types of lending for commercial purposes. In 1998, the Central government re-capitalised the Big Four ($34 billion) and established asset-management companies (AMCs) and paired them with the banks to help balance sheets. New accounting standards were also put in place to make it difficult for the Big Four to hide their bad loans.

The 1994 round [of industrial policies]…also targeted five pillar industries – machinery, electronics, petrochemicals, automobile, and construction – for “national promotion (Edin 2005: 112).”
Guonan Ma, a senior economist at the Bank for International Settlements estimates that China's bank restructuring costs has amounted to RMB4 trillion (USD500 billion) as of 2005. The Ministry of Finance and the PBOC have shouldered 85 percent of the bill so far, and the rest shared by shareholders and customers both foreign and local.

Despite the reforms of the 1990s, China’s NPLs have not significantly abated. As of 2006, China's NPLs may approach 30 percent of GDP. However, what the reforms have accomplished is the concentration of public loans away from small and medium enterprises to the bigger players of the strategic sectors mentioned earlier. Between 1995 and 1999, employment in state sector decreased by 26.9 million and increased by 50 million in the non-state sector. About one-third of the small and medium SOEs have been privatised resulting to a decrease of workers in the public sector from 113 million in 1995 to 67 million by the end of 2004.

The reforms post-1994 have also led to the concentration of risk among a smaller number of SOEs. Similar to Japan’s banking crisis in the 1980s, China now faces a concentration of loans in hand-picked “winners.” In Japan smaller firms which were not given preferential access to lending sought cheaper financing from capital markets abroad. This in turn quickly made the Japanese hand-picked “winners” into losers as their profitability fell.

While foreign observers laud these reforms, some things have not fundamentally changed. The banking system is still statist. The three policy banks and the Big Four are still majority state-owned (62 percent). Even alternative sources of financing, such as the stock market, are largely state-dominated. SOEs still receive the bulk of funds from SOBs.

The status quo, while having improved on the past, is clearly still unsustainable. As China transitions further into capitalism, the public sector cannot possibly shoulder losses for very long as this damages China’s overall competitive advantage. Preferential loans lent to the public sector have resulted to a ‘glut’ of credit to the more dynamic parts of the economy, the private sector, which now accounts for about 40 percent of total industrial output. The percentage of new loans that went to this emerging group actually declined from 22 percent in 1998 to 14 percent in 2003.

The transition to more market-based financial decisions has been painfully slow and deliberate, owing to the political and social roles played by China’s banking institutions vis-à-vis the rest of the economy. The reforms of the past decade have nominally ‘massaged’ the bank books so to speak, and have reduced the losses incurred by the public sector – but value-destroying financial activities are still significant.

The next session will discuss the strategies employed by the State in manoeuvring, as it were, the Chinese behemoth in the labyrinthine complexes of global capitalism.

4. China and Global Capitalism

While initial changes of opening up the local economy to Asian capital were made in the late 1970s and continued well into the 1980s, it was clear that China was indeed, 'feeling for the stones' as it crossed the river.

Even though reforms in China had been going on for more than a decade already,
the goal of reforming the country’s economic system was still vague. Some
economists and officials responsible for the reform claimed that improving the
existing planned economic system was their only goal. Others considered it to be
the creation of a market-type economy. These two approaches clashed for quite a
long time. As long as there was no clarity about the ultimate objective of
reforms, China was literally “groping” in the dark, the only viable approach
being to take on problems as they arose. If no solution was at hand, a problem
would simply be put on freeze. As a result, many steps taken in the context of
reforms were no more than a compromise, to last as long as a new solution could
be found. The “two-level” pricing system could be called a textbook example of
this. In the late 1980s, when runaway inflation was a serious threat, there was
a growing realization that for the backlog of problems to be resolved, the goals
of reform in the economic system were to be clearly defined as soon as possible
(Zhang 2003: 40).

The 1990s finally saw some clarity China’s strategy by charting its course into what it has termed a ‘socialist market economy’ a duality of centrally-planned and market-based systems. This was a strategic choice that saved China from the US-sponsored ‘shock therapy’ experienced by former Soviet satellites in Eastern Europe.

Among the other ‘shocks’ of the 1990s was the Asian financial crisis of the 1997. Unlike its other East Asian neighbours China’s financial markets were little penetrated by highly mobile foreign capital, and thus remained unscathed. Even so, the Chinese realised that its interdependence with the global economy, while having been instrumental in its miracle growth, could also become a source of insecurity. This cautionary tale was clearly taken into account by the Chinese leadership as Jiang Zemin addressed the 15th Party National Congress. Even as he underlined the need to deepen reforms and continued engagement with the global economy, as well as the continued improvement and independence of China’s local enterprises, he emphasised the need for measured steps:

We shall use foreign capital actively, rationally and effectively. We shall
open the service trade step by step. In accordance with the law, we shall
protect the rights and interests of foreign-funded enterprises, grant them the
same treatment as their Chinese counterparts and improve guidance to and
regulation of these enterprises. We shall encourage Chinese investors to invest
abroad in areas that can bring China's comparative advantages into play so as to
make better use of both Chinese and foreign markets and resources. We shall
improve and enforce laws and statutes governing China's trade and economic
relations with foreign countries. We must correctly handle the relationship of
opening up versus independence and self-reliance, and safeguard the economic
security of the country (Zemin 1997).

Chinese academics engaged the Western conceptualisations of ‘globalisation’ and ‘interdependence’ with caveats. It was recognised that markets, production and capital had become truly global in the 1990s, and that the best way to manage globalisation was through multilateralism. Increasingly questions of the economy and environment were also being addressed, as well as issues which transcended borders and needed transnational solutions. Information revolution is recognised as the most important component of globalisation.

Chinese scholars were also cognisant that interdependence does not mean everyone can win. They cite the example of the Plaza Accord signed by the Japanese in 1985. The United States forced Japan to make significant concessions which undermined its economy (perhaps leading to the recession). Not coincidentally these changes took care of the American deficit vis-à-vis the US.

Thus began the elaborated concept of ‘security’ in Chinese strategic thinking. From 1978 to 1992, economic growth and national security maintained two separate logics. The boundary between the two became increasingly blurred in the mid 1990s. National economic security became the “most popular topic for Chinese scholars and policy-makers after the mid-1990s (Wang 2004: 528).” China’s defence white papers of the past few years are indicative of this trend.
…China's security still faces challenges that must not be neglected. The growing
interconnections between domestic and international factors and interconnected
traditional and non-traditional factors have made maintaining national security
a more challenging task (Chinese Defence White Paper 2006).

China had to prepare for economic warfare – a threat much more difficult to detect than conventional ones. It was understood that “through US power in international financial institutions, US power and hegemony can be imposed on the world—and on developing states in particular — without the use of brute military power (Breslin 2004: 663).”

It is with this kind of thinking in mind that the Chinese state carefully regulates its engagement of the global economy and vice versa. For example Chinese scholar Ye Fujing conceptualises the term ‘national financial security’ as “the ability of a financial system to function and develop organically, to the extent that it can withstand, rather than be controlled by, international capital supply/demand shocks (2007: 560).”

Financial security should be characterised not only by stability (i.e. resistance to external shocks) but also sovereignty – to ensure that foreign financial institutions do not control the local financial market and institutions and that market shares of overseas financial companies do not exceed fifty percent.

He then goes on to cite examples dating back to the late 19th century of how American banks behaved as oligopolies – with strong support of the state sector. Sovereignty is ensured by the National Banking Act of 1863 which required that officials of banks and insurance companies operating in the United States – whether domestic or foreign - must be American citizens.

‘Sovereignty’ of other advanced capitalist economies was also cited. In 2004, for example, foreign banks had a 1.4% market share in Germany, 2.8% in France, 1.3% in Japan, and the largest share—at 12%—in Spain (Ye 2007: 573).

With regard to the Asian financial crisis, some Chinese observers apparently do not discount that the ‘Asian miracle’, i.e. the Asian model of capitalism, was undermined by Western speculators deliberately.

When Asian nations called for strict regulations on transnational
speculations, Western governments led by the Clinton Administration insisted on
protecting free capital flows. The international rescue plan designed by the IMF
imposed rigid conditions on Asian nations and required them to open their
domestic markets at the climax of recession. The consequence was that Westerners
suddenly found they could get into the once-forbidden fields in Asian markets by
purchasing local companies at unimaginable low prices (Zhu 2001: 53).

Capital account liberalisation and WTO Commitments

A stable and regularised access to external markets forms the backbone of China’s export-oriented external economy. Accession to the World Trade Organisation in 2001, which was negotiated over a fifteen year period, finally guaranteed China access to the panacea of the Asian developmental state model – US markets.

Upon accession to the WTO, China agreed to a five-year phase in for banking services by foreign banks. On December 11, 2006, China fully liberalised its financial markets to meet its WTO obligations. Foreign banks must now be allowed to play on a level playing field as local ones. Foreign banks in operation more than doubled from 69 in 2000 to 173 in 2005. Beginning in 2004 more foreign investors were also allowed to buy shares in Chinese banks (Tong & Zheng 2007).

Authorities expect that competition from foreign players would lead to qualitative improvement of the banks’ governance. But more than such technical fixes, the WTO commitments, as an external driver, were expected to further reforms of the protected domestic state sector – namely the SOEs and SOBs – which the State could not accomplish through domestic channels given their political sensitivity.

A haphazard liberalisation of the Chinese capital account could lead to depositors rushing to move savings to foreign banks given the questionable record of domestic institutions. As such, the US has called on China’s failure to remain on schedule with its WTO commitments and the protectionist measures it adopted prior to the December 2006 deadline. A month before, the State Council issued the Regulations for the Administration of Foreign-Funded Banks. This mandated that only foreign-funded banks that have had a representative office in China for two years and that have total assets exceeding $10 billion can apply to incorporate in China. After incorporating, moreover, these banks only become eligible to offer full domestic currency services to Chinese individuals if they can demonstrate that they have operated in China for three years and have had two consecutive years of profits (USTR 2007: 89).

A second bone of contention with regard to China’s financial system is its exchange rate regime. China has been pressured to revalue the Renminbi (RMB) since 2003. While China has allowed its currency to float within a narrowly defined band since July 2005, it has been reluctant to heed calls of the international community. While it is not clear whether US trade deficit with China would improve were the RMB to revalue, the US Treasury Department has “strongly urged” China to allow the RMB to float. It has even considered legislation that would penalise China if it does not do so. There are mixed data on how much (if at all) the RMB is undervalued. The IMF claims it is undervalued, but they cannot say by how much.

China refused to bow to pressure because in the international game of ‘problem assignment’, China has so far refused to accept that the US trade deficit is its problem.

As of October 2007, even as the financial markets looked increasingly problematic due to the sub-prime crisis in the United States (EIU 2007), China has not changed this policy stance. In an address to the IMF, the PBOC’s deputy governor had this to say:

We believe that the Fund’s exchange rate surveillance should focus on whether a
member country’s exchange rate regime is consistent with its medium-term
macroeconomic policies, rather than on its exchange rate level. Given the
apparent weakness in the concept and measurement of the equilibrium exchange
rate, its estimation can serve only as one of references for technical analysis,
but not as the basis for the assessment of members’ policies. We hope the Fund
will fully recognize the diversity of members’ situations, the limited role
exchange rates play in macroeconomic management and the limitations of the tools
used for exchange rate analysis. We also hope that the Fund will respect the
autonomy of its members in choosing exchange rate regimes (Wu 2007: 7).

China has indeed taken advantage of expansion of credit in the US economy for the last decade, having been one of its most robust export markets. Now that the US is in recession (Scopical News 2008), it will be interesting to see if China will finally devalue its currency and begin a serious undertaking of cultivating its own domestic markets.

5. China’s Grand Strategy: From Rule-taker to Rule-maker?

Belatedly, US officials have noted the country's financial insecurity vis-a-vis China. "We are so dependent upon decisions made in other countries' capitals" says Senator Hillary Clinton. In a discussion she had with a retired general, she was given the nightmare scenario of the PRC finally invading Taiwan with the US unable to defend the island because Beijing might well say "Fine. You do that, we will dump your dollars. We will flood the market. We will not buy any more of your debt (Mason 2008)."

The United States-China Economic and Security Review Commission cites as issues of concern China's trade surplus with the US. As of November 2007 this was at $163.8 billion. Its foreign currency reserves is at $1.43 trillion, 70 percent (or 1 trillion) of which are invested in dollar denominated assets, mostly in US sovereign and corporate bonds (USSC 2007).

As the US domestic economy falls into recession, China will have saved more than enough for the rainy days coming ahead and may be better able to weather the economic storm in its primary export market. The PRC will also have enough foreign reserves to continue importing vital commodities such as crude oil. And as the US dollar continues to fall in value, China may well decide to unload its holdings to switch to more stable currencies, such as the Euro. Various Chinese officials have already said as much. Because Chinese business interests are also state interests, any pronouncements of such kind are always treated as political threats. Former World Bank chief economist and US Treasury Secretary Larry Summers has used the term 'balance of financial terror' echoing the nuclear stand-off between the Soviets and the US during the Cold War. If China does decide to unload its US dollars en masse, will it be shooting its own foot? In turn, how will the US react?

Due to the credit crunch brought on by the sub-prime crisis, Chinese financial institutions have also been taking advantage of the 'fire sale' in the heart of the American financial capital, acquiring shares in long-standing US financial institutions such as Blackstone and Morgan Stanley (Straszheim 2007). Meanwhile, the collapse of Bear Sterns, with which China’s Citic Securities had cross-investment deals to the tune of $1 billion, has been a learning experience for Chinese players to tread more cautiously. Nevertheless, China’s financial instruments will continue its global expansion (Zhao 2008).

In September last year, the PRC created the China Investment Corporation (CIC) to further venture into the weird, wired world of global capital markets. This new economic policy arm will take charge of China's gargantuan foreign currency reserves. European and American politicians have already expressed worry that the CIC will purchase shares in other countries’ sensitive industrial sectors - and may be used as political leverage in the future. The CIC’s chief risk officer quickly allayed any such suspicions by saying that “The claim that sovereign-wealth funds are causing threats to state security and economic security is groundless…We don't need outsiders to come tell us how we should act (WSJ 2008).”

Given such patterns it is apparent that China is well on its way to flexing its financial muscles and has been successful at playing the high finance game. One would think that the PRC has been taking pointers from Samuel Huntington’s Clash of Civilisations – that the path to global leadership and power entails owning and operating the international banking system, controlling hard currencies and dominating international capital markets.

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