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Corporate Governance, Corporate Context

Is there a real private sector in China ?

China Hearings, Portcullis House, May 23rd 2007

An appeal against investor naivety !

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Theme - understanding risks ‘at the level of the firm’ GENERAL TOPICS …

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 & whitewhite’

Strategic plans vs. ‘the law of unintended consequences’

Conclusions for economists and foreign investors

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

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Understanding better Chinese economic risks and pitfalls

Some unusual features of the Chinese economyIt’s not just the growth and size of the economy that is unusual……..

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The China growth story & ‘problem by-pass’ strategy

Export-led growth. (Exports 35% GDP in 2004 – 40% 2005, 40%+ 2006)

Government revenue up as % GDP growth sectors more easily taxable1994 govt revenue 11% of GDP – 2006 24% GDPBudget deficit 2006 1.4%GDP

China's GDP grew 10.7 percent to $2.7 tr. in 2006Target 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)

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There is no ‘model’ – economic factors are unique

The state is still ever-presentState sector still more than a third of GDPFour huge state banks – central policy but commercial lending decisions at provincial levelVery 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 GDPInvestment funded by debt at low interest – thin markets for equity capitalLow returns on investment, even lower in state sectorLow consumer spending - huge savings but very low interest ratesUnreliable 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 functionMonetary policy heavily influenced by fears of unemployment and even more civil unrest

‘Prediction has no future’

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Conventional wisdom ?

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

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‘The private sector is the engine of growth’

1998 1999 2000 2001 2002 2003 Chg.

Private sector

50.4 51.5 52.8 55.5 57.4 59.2 8.8

Public sector

49.6 48.5 47.2 44.5 42.6 40.8 -8.8

State controlled 36.9 37.1 37.3 35.7 34.6 33.7 -3.2

Collective 12.7 11.3 10 8.8 8 7.1 -5.6

Total % GDP 100 100 100 100 100 100

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

% of added value by firm ownership

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Rates of return are low – but the private sector does better

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Something is not quite right…

Look again at China’s unusual economic landscape

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Runaway investment ? (Investment as a % of GDP)

> ‘Infrastructure building is 45% of GDP’ - CEIBS Shanghai

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The advent of ‘free financing’ in China

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Aggregate lending raises further concerns

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).

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Historic NPL rates suggest unsustainability

0

1

2

3

1998 1999 2000 2001 2002 2003

Chinese bank sector lending 1998-2003

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).

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China risks: End of the low inflation era ?

‘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 ?’

What happened to last year’s fears ?

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Do serious economic risks remain ?Efforts to contain growth have not been fully successful

‘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)

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)

‘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)

‘Changes to bank reserve requirement have had successful short term effects’ Central Bank Governor Dai Xianglong May 2005

‘The apparent effects [cooling investment] have been achieved.’ Ma Kai, Minister at the State Development and Planning Commission (March 05)

The People’s Bank of China (2004) criticized ‘the blind expansion of seriously low quality, duplicate projects’ in steel, aluminium, and cement’.

The Chinese Government expressed ‘concern about the impact that a large change in the renminbi might have on employment’. – IMF ‘04

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

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Why ? – Much lending is still political.

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

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Hence the question…

Is there are real private sector in China ?How private is private ?

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

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Understanding private sector development in China

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 ?

Some key questions

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The progress of the private sector in China, post-1979

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

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Ownership, status, & quasi-privatization changes

Corporatisation, marketisation & partial MBOs, more than privatizationRepatriation 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 marketsSmall %s of SOE equity listed & traded – extrapolation to market cap unwiseOverall 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 and same-firm, manager-owned Cos. enables tunnelling of assets

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

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

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

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

Year Trends Composition of private shares

Private shares in all firms Private shares in privatizing firms Management Employees Outsiders

1996  4.1 61.6  0.5 24.2 75.3

1997  5.3 57.2 13.3 26.2 60.6

1998  7.1 61.1 13.2 30.5 56.3

1999 12.1 65.2 14.5 27.9 57.6

2000 20.9 76.4 21.4 32.5 46.1

2001 26.1 80.4 25.7 34.1 40.2

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Chinese state-owned & quasi-state enterprises

More than 1400 ‘listed’ SOEs= 2/3 assets, ½ urban workers, ¾ investment & creditInsiders: most directors are executive + state reps, party appointees60%+ of shares non-traded, complex holding structures increase opacityMost receive overt or covert subsidiesOne third officially makes losses

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Pragmatic approach to SOE reform and ownership changes…BUT… ‘the law of unintended consequences’ applies

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

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)

CRS ‘failed’ (WB survey). Need to replace oscillating control vs. autonomy, local/national etc

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.

Codes and Standards of Corporate Governance of Chinese Listed Companies 2001 + independent directors system, for insider problem

1999 4th. mtg/15th National Congress – ‘Modern Enterprise system’ recognises corporate governance as core further reform needed

Shanghai Stock Exchange: March 2000 – new CG rules for listed firms

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.)

2001 New SPC legal framework to allow investors to sue listed companies for losses caused by false financial disclosures.

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The private-but-not-private approach brings problems

Pre-IPO manipulation is common

Some very major capital market scandalsChina 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’

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Some consequences of fudged state/private ownership

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 transactionsTo 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’.

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

Listing (eg 20% of target subsidiary)

Head Office

Subsidiaries

Profit

Profit

CostsDebtComplex

Crossholdings

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

State enterprise State enterprise managers

Joint venture

Land

Cash

Workers’ time

Building materials

Machinery

Repatriated cash from HK etc

Profit agreement

JV

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CONCLUSIONS & RECOMMENDATIONS

For foreign investors and the Chinese Government

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The impact on foreign investment decisions

‘Not so fast………….’

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Investment choices in China are more complex

Partners, suppliers, customers can be subject to political decision-making

Understand ownership structures, especially quasi-state and complex cross-holdings

Choose provinces and localities carefullyconsider especially competition with provincially-owned firms

Short term profit can dominate decision-makingnot share value or net assets

RPTs, tunneling, and propping may be prime motivatorsRent-seeking may dominate

‘Executives may have many hats’

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Public policy

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In line with Hu Jin Tao’s ‘market socialism fairness’ policy

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’

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New Chinese reforms might be less technocratic

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 regulationDisincentives for complex crossholdings & opacity

An end to tunnelling and propping

The beginnings of laws against monopolistic & unfair practicesNo more price hike riots ?