China Hearings, Portcullis House, May 23 rd 2007

Corporate Governance, Corporate Context

Is there a real private sector in China ?

Global Economic Policy Institute An appeal against investor naivety !

Theme - understanding risks ‘at the level of the firm’

GENERAL TOPICS …

Global Economic Policy Institute

Summary of unusual features of the Chinese economy…

The importance of the private sector in China Behaviour of the economy – something looks wrong Why ‘ state & private ’ is not so ‘ black &

white

’

Strategic plans vs. ‘the law of unintended consequences’

Conclusions for economists and foreign investors

Disclaimer: all conclusions and data are indicative & subject to verification.

Understanding better Chinese economic risks and pitfalls Global Economic Policy Institute

Some unusual features of the Chinese economy

It’s not just the growth and size of the economy that is unusual……..

The China growth story &

‘problem by-pass’ strategy

Global Economic Policy Institute Export-led growth. (Exports 35% GDP in 2004 – 40% 2005, 40%+ 2006) Government revenue up as % GDP growth sectors more easily taxable 1994 govt revenue 11% of GDP – 2006 24% GDP Budget deficit 2006 1.4%GDP China's GDP grew 10.7 percent to $2.7 tr. in 2006 Target was 8% Target for 2007 – 8% again (IMF forecast 10.0%) Growth mainly from private & coop sectors, BUT 100m workers remain in state enterprises; some profitable but most unprofitable - huge debts PRC government has a ‘problem by-pass’ strategy – to see new ‘private’ sector engulf the problem SOEs, gradually deal with SOE-related debt

‘If growth rate exceeds 11 percent, inflation would jump heavily and lead to overheating’

(Fan Gang - Chinese Government - Monetary Policy Panel)

There is no ‘model’ – economic factors are unique

Global Economic Policy Institute The state is still ever-present State sector still more than a third of GDP Four huge state banks – central policy but commercial lending decisions at provincial level Very large non-performing loans (NPLs) – to state sector (bigger than savings ?) The Party at all levels still involved in corporate governance & investment choices Unprecedented size of investment as a % of GDP Investment funded by debt at low interest – thin markets for equity capital Low returns on investment, even lower in state sector Low consumer spending - huge savings but very low interest rates Unreliable accounts and financial data – huge NPLs with private sector too ?

Small proportion of enterprise equity traded Understandable political knife-edge… Largest peacetime migration ever - 200m+ went East !

Unprecedented rise in FX reserves – very conservative treasury function Monetary policy heavily influenced by fears of unemployment and even more civil unrest ‘Prediction has no future’

Conventional wisdom ?

Global Economic Policy Institute Growth comes from the new private sector… …plus inefficient-but-vast & well-resourced mega state-firms in protected sectors.

‘Opening up policy’ – foreign investors are welcome to join in

‘The private sector is the engine of growth’ Global Economic Policy Institute

1998 Private sector Public sector State controlled 50.4

49.6

36.9

Collective 12.7

Total % GDP 100

% of added value by firm ownership

1999 2000 2001 2002 51.5

52.8

55.5

57.4

2003 59.2

48.5

37.1

11.3

100 47.2

37.3

10 100 44.5

35.7

8.8

100 42.6

34.6

8 100 40.8

33.7

7.1

100 Chg.

8.8

-8.8

-3.2

-5.6

% value added – GDP. Source; NBS & OECD ests.

Rates of return are low – but the private sector does better Global Economic Policy Institute

Look again at China’s unusual economic landscape Global Economic Policy Institute Something is not quite right…

Runaway investment ? (

Investment as a % of GDP) Global Economic Policy Institute

>

‘Infrastructure building is 45% of GDP’ CEIBS Shanghai

The advent of ‘free financing’ in China Global Economic Policy Institute

Aggregate lending raises further concerns Global Economic Policy Institute

From ‘Fixing China’s Banks, Not Russia’s’ by Michael S. Bernstam and Alvin Rabushka ‘The major problem in China's fast growing economy is the quality of investment’

– IMF (WEO 2005).

Historic NPL rates suggest unsustainability Global Economic Policy Institute

Chinese bank sector lending 1998-2003

3 1 2 0 1998 1999 2000 2001 2002 2003 Non-performing Performing loans

Bank of China's NPLs were found to be 2.6 times as high using international criteria as they were using the traditional Chinese definitions (N Lardy 2001).

China risks: End of the low inflation era ?

Global Economic Policy Institute What happened to last year’s fears ?

‘PBC sterilisation of money supply, reserve ratio hikes, and temporary ‘commands’ to banks & SOEs – at the end of the administrative measures road ?’ ‘It is more difficult to achieve a soft landing as the investment excess is much greater than 2002/3’ (Morgan Stanley 03.05) ‘WTO membership opens up banking sector in 2007 – reform timetable is tight (foreign banks will take deposits and ‘good loans ?’)’ ‘1 yr deposit rate only 2.25% AND Grey market loans 8%-20% = unsustainable monetary expansion & inflation ?’

Do serious economic risks remain ?

Efforts to contain growth have not been fully successful Global Economic Policy Institute ‘I don't see the necessity to raise interest rates again’ (Guo Shuqing, Director, China's State Administration of Foreign Exchange - Bloomberg March 05) (Dr Guo also ruled out a large scale appreciation in the renminbi) The Chinese Government expressed ‘concern

about the impact that a large change in the renminbi might have on

employment’. – IMF ‘04 Inflation will ease to 4 percent or less in 2005 – [from a seven-year high of 5.3 percent in July and August 2004] (Premier Wen Jiabao March 05) The People’s Bank of China (2004) criticized ‘the blind

expansion of seriously low quality, duplicate projects’ in steel, aluminium, and cement’.

‘Credit curbs that were imposed last year on

overheated industries like steel, cement and property, cannot be loosened. Land use will be more strictly regulated to stop illegal construction’

(Premier Wen Jiabao March 05)

‘The apparent effects [cooling investment] have been

achieved.’ Ma Kai, Minister at the State Development and Planning Commission (March 05) ‘Changes to bank reserve

requirement have had successful

short term effects’ Central Bank Governor Dai Xianglong May 2005 The central parity rate of yuan against U.S. dollar has appreciated by only 5.54 percent since July 2005, when the yuan-dollar peg was ‘scrapped’. Bank of China

Why ? – Much lending is still political.

Global Economic Policy Institute

2/3 of SOCB loans still to prop up state-owned enterprises.

‘The best way to get capital in China is to be too big to fail’.

Local governments have ‘blueprints’ & borrow at short notice for new projects, & for JVs & FIEs New ‘quasi-banks’ (Q-Bs) are defying administrative belt tightening in SOCBs SOE/local government borrowing unaffected by higher interest rates at Q-Bs (10%-20%) - secured on undervalued assets ?

Negative real interest rates = private capital flight to new Q Bs ($25-$30bn fled to QBs in 2004*)

* John Dessauer, Investor’s World, Jan 05 ** Economist Oct04

Hence the question…

Global Economic Policy Institute

Is there are real private sector in China ?

How private is private ?

The economy is not behaving like a private-sector-led system

Understanding private sector development in China

Global Economic Policy Institute

Some key questions

How much of the private sector-led growth is from new private sector companies, and how much from ‘privatised companies’ ?

How are the new private sector companies formed ?

Are they really private entrepreneurs ?

How does the privatisation process work ?

Are privatised firms really private ?

The progress of the private sector in China, post-1979 Global Economic Policy Institute Rural agriculture and individual business (1978-1984) Local privatization of SMEs (1995- )

officials often buyers

‘Contract responsibility’ reform in state-owned and collective enterprises, 1984-95, led to….

…‘Legalisation’ of urban individual businesses Collective + individual ownership TVEs 1978-2006 . 2002 onwards – new urban start-ups (& 2007 private asset law)

‘The United Front Work Department of the Central Committee of the Communist Party of China has recognized

business people and professionals as a new pillar of socialism with Chinese characteristics’. China Daily July 06

Ownership, status, & quasi-privatization changes

Global Economic Policy Institute Corporatisation, marketisation & partial MBOs, more than privatization Repatriation of exported funds to HK/Taipei, replaced by……. …..administrative insider (MBO) private ownership schemes (scams ?)

>>

Much confusion over terms & definitions

Complex, pragmatic sequence of SOE rule changes in capital markets Small %s of SOE equity listed & traded – extrapolation to market cap unwise Overall financial picture of group finances (esp. debt) obscured ?

Which entity in the crossholding structure is listed ?

ROI requirement system – few disincentives to prop up on-paper profits ‘20% rule’ in privatisation very loosely interpreted by officials JVs between

state firms

tunnelling of assets and

same-firm, manager-owned Cos

. enables

‘Privatisation.. is constrained by excessive debts and worker redundancy’

KAI GUO & YANG YAO (Beijing Univ.) Economics of Transition, April 2005 .

>>

PRIVATIZATION: Returning ‘foreign’ capital is being replaced by direct management ownership – investors beware !

Year Trends Composition of private shares

Global Economic Policy Institute

Private shares in all firms 1996 4.1

1997 5.3

1998 7.1

Private shares in privatizing firms 61.6

57.2

61.1

Management Employees Outsiders 0.5

13.3

13.2

24.2

26.2

30.5

1999 12.1

2000 20.9

2001 26.1

65.2

76.4

80.4

14.5

21.4

25.7

27.9

32.5

34.1

Guo, Kai & Yao, Yang. Causes of privatization in China .The Economics of Transition Feb 05

75.3

60.6

56.3

57.6

46.1

40.2

Chinese state-owned & quasi-state enterprises

Global Economic Policy Institute More than 1400 ‘listed’ SOEs = 2/3 assets, ½ urban workers, ¾ investment & credit Insiders: most directors are executive + state reps, party appointees 60%+ of shares non-traded, complex holding structures increase opacity Most receive overt or covert subsidies One third officially makes losses

Pragmatic approach to SOE reform and ownership changes…

BUT… ‘the law of unintended consequences’ applies Global Economic Policy Institute

1979-1991 Autonomy reforms (SOE Contract Responsibility System post 1987, & SOE law 1988)

+

separation of various property & managerial rights, recognition of ‘management techniques’, role clarity CRS ‘failed’ (WB survey). Need to replace oscillating control vs. autonomy, local/national etc Shanghai Stock Exchange: March 2000 – listed firms new CG rules for Codes and Standards of Corporate Governance of Chinese Listed Companies 2001 + independent directors system, for insider problem Continuing inefficiency + problem of information asymmetry + competing control claims = need for formal system for

state

bodies to share ownership & control… 1992/3 Use of company law, SOE corporatisation, & standardised corporate governance rules. Many state SMEs became ‘private’ (20% of other SOEs could be ‘private’, but this was loosely defined). Ownership/control confusion persists at some levels.

Further waves of measures to address SOE debts – AMCs initiative emerged.

1999 4th. mtg/15th National Congress – ‘Modern Enterprise system’ recognises corporate governance as core further reform needed 2001 New SPC legal framework to allow investors to sue listed companies for losses caused by false financial disclosures.

1st mtg of the 10th National People’s Congress, the State owned Assets Supervision and Administration Commission of the State Council (SASAC) – supervises large SOEs & mediates between state institutions – cumbersome, monitoring, supports senior SOE managers June 2003 1/3 independent directors a requirement. Some scope for personal liability of directors.

Rise of Authorized Investment Institutes (ie Holding company, National Assets Management Co, Group Co.)

But, by 2005 - Supreme People’s Court - 1,000 suits against 14 listed firms for losses arising from false financial disclosures, none settled by Court in favour of investors (RIIA Naomi Li)

The private-but-not-private approach brings problems Global Economic Policy Institute

Pre-IPO manipulation is common Some very major capital market scandals

China Eagle $752m, ICBC $893m, CCB $18m, Xinjiang Delong $249m, China Securities $687m etc etc etc ‘Accounting problems’: Yi’an Keji, Yinguangxia, Lantian Gufen, MaiKeTe

‘Propping & Tunnelling’

Some consequences of fudged state/private ownership Global Economic Policy Institute State-linked corporate insiders managing ‘returns’ Especially if ‘private’ owners are local government Related party transactions (RPTs) - shifting of resources between controlling owners and listed firms with complex crossholdings … ‘Propping’ to meet securities regulators’ ROI earnings targets for…..

…share issuance …maintaining listing status Creates scope for ‘tunnelling’ via inter-state-company trades… To enhance rent-extraction transactions To extract wealth from the firms See Propping and Tunneling through Related Party Transactions MING JIAN & T.J. WONG January 2006 - Chinese University of Hong Kong and SUG at Nanyang Technological University.

Their academic language studiously avoids the word ‘theft’.

‘Propping’… how does it work ? – an example

Debt Head Office Complex Crossholdings Subsidiarie s Profit Profit Global Economic Policy Institute Costs

Listing (eg 20% of target subsidiary)

‘Tunnelling’… how does it work ? – an example

JV

State enterprise

Global Economic Policy Institute

State enterprise managers

Land Cash Workers’ time Building materials Machinery Profit agreement

Joint venture

Repatriated cash from HK etc

CONCLUSIONS & RECOMMENDATIONS

For foreign investors and the Chinese Government

Global Economic Policy Institute

Global Economic Policy Institute

The impact on foreign investment decisions

‘Not so fast………….’

Investment choices in China are more complex

Global Economic Policy Institute

Partners, suppliers, customers can be subject to political decision-making Understand ownership structures, especially quasi-state and complex cross-holdings Choose provinces and localities carefully consider especially competition with provincially-owned firms Short term profit can dominate decision-making not share value or net assets RPTs, tunneling, and propping may be prime motivators Rent-seeking may dominate ‘Executives may have many hats’

Public policy

Global Economic Policy Institute

In line with Hu Jin Tao’s ‘market socialism fairness’ policy Global Economic Policy Institute

What changes in economic & social policy might be afoot ?

Political pragmatism in capital market development & ownership changes will stop..

..Will be replaced by a strategy of fairness & wide share ownership (to prevent a Chinese ‘megagarchy’) Hu Jin Tao’s old guard will thus become ‘modernisers’

New Chinese reforms might be less technocratic

Global Economic Policy Institute

Role of the Party – withdrawn from governance But in its place – an actual strategy towards ownership

(international help needed)

New collective ownership legalities SME equity protected – individual economic rights Equity markets instead of land grabs Re-integration of the ‘9 ownership rights’ Principles-based financial regulation Disincentives for complex crossholdings & opacity An end to tunnelling and propping The beginnings of laws against monopolistic & unfair practices No more price hike riots ?